An analysis of stress tests and their usefulness

Abstract

The 2008 financial crisis which was triggered by the failure of the Lehman Brothers’ Bank unleashed severe repercussions worldwide. In particular, this crisis laid down to rest the myth that certain banks are too big to fail. It brought to the fore the need for additional macro prudential analytical tools to help anticipate and undertake preventive and remedial action in time to help limit the frequency and severity of financial crises. One such important tool at the disposal of regulators and supervisors is bank stress testing. In fact, bank stress testing is being increasingly embraced as a prominent tool in the financial supervisory arsenal through which the performance of individual banks and the overall resilience of the financial system is examined under adverse but plausible economic scenarios. Stress tests in effect simulate risk assessment and management at both the portfolio and systemic levels. Nevertheless, despite their extensive use at both the micro and macro levels by financial institutions around the world, stress tests are still the subject of much debate about their usefulness. This study seeks to contribute to this debate by confronting the main issues, objectives and methodological approaches as teased out of the literature review with the reality of the European Banking Authority’s 2011, 2014 and 2016 stress test results. This is done through a quantitative and qualitative analysis of the test results. The picture that emerges from this study regarding the usefulness of the EBA’s stress tests framework is a mixed one. In fact, the analysis shows that the said stress tests have been useful and practical in certain respects and questionable in others. In effect, it transpires that they have been useful for decision making by the regulatory and financial authorities at the individual bank level as they have been instrumental in compelling weak banks to restructure and strengthen their capital position. However, they have been less effective and useful in injecting confidence in both market participants’ and in financial institutions and markets to boost ailing economies. They have also been unsuccessful as early warning devices. In light of this, the study recommends that the EBA stress testing framework makes use of at least two extreme scenarios as already employed by the US and also the UK as from 2017, enhances model robustness, transparency and tractability and captures the inter-linkages between the bank and nonbank sectors and the real economy. Bank stress tests are still a work in progress. Hence, their potential cannot be underestimated. They are challenging, particularly at the macro level. These challenges can be overcome through a combination of capacity building, fine tuning and the uptake of insights gained from past tests and further research.