Perhaps one of the most important risk activities a bank should initiate or enhance over the coming years ahead is stress testing. The stress testing framework, not that risk analysts currently see it as that, is probably going to be the next best thing and the only viable commercially alternative for reducing financial sector fragility other than crippling regulation or bailouts.
In this blog we look at why banks have been failing their stress tests.
The Stress Test
Earlier on this year the Bank for International Settlements released an interesting paper on why stress testing just doesn't work. Let's be totally real, it hasn't worked has it and there are so many financial institutions that have supposedly passed a regulatory stress test, only to hit the wall of bankruptcy shortly after. For example; Dexia, the European lending dream did really well in the European regulatory stress tests but was bankrupt six weeks after it was deemed safe.
The Bank for International Settlements has gone so far as to state "No macro stress test carried out ahead of the credit crisis identified the build-up of vulnerabilities". That is an incredible statement to make but it is not the only horror written up in the BIS 369 working paper. The paper can be downloaded directly from the Bank for International Settlements by following this [LINK] and I urge risk managers in banks to take a look.
The flaws in existing stress tests | Causal Capital [Click image to enlarge]
We have taken to highlight the key reasons why stress tests are not working and in the coming days ahead, a framework for stress testing will be published on this blog. All the points listed in the diagram above (which can be enlarged by clicking on it) have been selectively drawn from the BIS 369 working paper.