Bank Stress Test

What is a Bank Stress Test?

This is an analysis that is executed under hypothetical unfavourable economic situations like a financial Market crisis or deep Recession. Bank stress test is designed to evaluate whether a bank is capable of withstanding the effect of adverse economic situations.

Such tests are either conducted by the risk management teams of the bank or Reserve Bank of India.

How does a Bank Stress Test Work?

To comprehend the financial health of a bank during the time of crisis, stress tests majorly focus on a few specific areas, like market risk, liquidity risk and credit risk. With the help of computer simulations, experts create several hypothetical crisis situations.

All of these tests comprise a common set of situations. For a bank to experience these situations, some of them could be worse in comparison to others as well. Generally, a hypothetical situation may consist of a disaster in a certain place – say a hurricane or a major war.

Or, it may also include some situations that lead to the increasing unemployment rate, increasing property prices, a dip in stocks, and more. Once these situations are created, banks use the upcoming nine quarters of the reported financials to comprehend if they carry enough Capital to survive the crisis or not.

Bank Stress Test Results

Banks and financial institutions that get to undergo the stress tests are needed to publish their bank stress test results. Then, these results are released to the public so as to show how the bank is going to Handle the significant financial or economic crisis.

In case a bank fails to pass the stress test; obviously, they are going to have a bad Impression in public. Also, they would have to cut down the dividend payouts and share buybacks to keep or build the capital reserves.

Not just small and mid-scale banks, even prestigious financial institutions have failed this test several times. In some situations, banks are provided with a conditional pass in terms of a stress test. This means that the bank is just close to failing and risking its ability to make any future distributions. Such banks, with a conditional pass, must resubmit a new plan of action to get back on track.