What Is a Stress Test?
At its simplest, a stress test is a way of revaluing a portfolio using a different set of assumptions. The results of a stress test show the sensitivity of the portfolio to a particular shock.

Stress tests can be useful because for most asset markets, the history of returns does not provide sufficient information about the behavior of markets under extreme events. Stress tests complement traditional models with estimates of how the value of a portfolio changes in response to exceptional but plausible changes in the underlying risk factors.

In individual financial institutions, stress tests have become widely used as a risk management tool to assess a variety of risks, including market risk (losses from changes in prices or yields), credit risk (losses from borrower defaults), and liquidity risks (illiquidity of assets and depositor runs). Gradually, the techniques have been applied in a broader context, with the aim of measuring the sensitivity of a group of institutions (such as commercial banks) or even an entire financial system to common shocks.

However, most stress tests applied at the system level are really only performed on a subset of institutions and often ignore many of the complex institutional links that are inherent in any financial system. Thus, it may be more appropriate to describe stress tests of a financial system as “system-focused” stress tests, to acknowledge the limitations inherent in undertaking such an exercise.

System-focused stress tests, as the name implies, have several important differences from portfolio-level stress tests used by individual firms. The ultimate intent of system-focused approaches is to identify common vulnerabilities across institutions that could undermine the overall stability of a financial system. ...

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This pamphlet is based on IMF (www.imf.org) Working Paper WP/04/127, “Stress Testing Financial Systems: What to Do When the Governor Calls,” by Matthew T. Jones, Paul Hilbers, and Graham Slack, July 2004.

Concluding Remarks
Stress testing is best seen as a process of identifying vulnerabilities and providing an estimate of the sensitivity of balance sheets to a variety of shocks.

System-focused stress tests attempt to link a forward-looking macroeconomic perspective with an assessment of the sensitivity of a group of institutions to major changes in the economic and financial environment.

The process of conducting a system-focused stress test begins with the identification of specific vulnerabilities or areas of concern, followed by the construction of a scenario in the context of a consistent macroeconomic framework. Isolating key vulnerabilities is an iterative process involving both qualitative and quantitative elements. A range of numerical indicators can be used to help isolate potential weaknesses, including the “big picture” or macro-level indicators, broad structural indicators, and more institution-focused or micro-level indicators. Ideally, an econometric or simulation model should form the basis of the stress-testing scenarios. A working group of selected experts may facilitate the process. ...

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