Stress Testing Bank Profitability

A defining difference of macro-style stress testing is the explicit consideration of profitability dynamics in the stress scenario. Traditional stress testing had focused almost exclusively on losses only, but a complete assessment of capital adequacy under stress must take into account not just the balance sheet but also the income statement. For instance, in the 2013 US stress test, reduction in projected income for the 18 mandatory bank holding companies (BHCs) covered nearly 60% of projected stress losses. We describe and discuss a framework for modeling the major components of the income statement for BHCs using the U.S. regulatory reports as an empirical illustration. We review approaches taken by the industry and trace its remarkable development in the wake of the financial crisis. We find--perhaps unsurprisingly and in line with previous literature--that successfully modeling profitability requires a tailored BHC-specific approach to revenue segmentation and modeling. We argue that failure to pursue a relatively granular income source segmentation along different business activities, far more granular than reflected in typical regulatory reports, will obscure significant underlying differences in macro risk factor sensitivities.