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A recent G-10 central bank survey of the stress tests used by large international financial institutions shows that stock market crashes and emerging market crises head the list of events that concern banks. But while these events are the most commonly simulated in bank stress tests, the risks covered by respondents stress tests span all major asset classes and all geographic areas.
As authors Ingo Fender, Michael S. Gibson, and Patricia C. Mosser explain, stress testslike other risk management toolsgauge how the value of an institutions portfolio of securities and derivatives will change with large movements in market rates and prices. But unlike similar tools, stress tests directly measure how extreme financial or economic events affect portfolio value at a specific point in time.
The stress test survey, conducted under the auspices of the Committee on the Global Financial System (a group established by the G-10 central bank governors), shows broad similarities in the types of risks tested by the forty-three participating banks. Nevertheless, individual stress test scenarios differ across the banks, with marked variations evident in the size of the shocks simulated and the assumptions made about cross-market effects. These variations, the authors note, reflect differences in the underlying portfolios and business lines of the participating institutions, as well as differences in the time horizons used in the tests.
Fender, Gibson, and Mosser state that the survey also casts light on how banks use stress tests in their overall risk management programs. Because stress tests provide a direct measure of a potential loss in portfolio value, risk managers regard the tests as an especially effective means of communicating risk to bank senior management. The tests are used to assess risks across the trading and lending businesses of banks and are often used by global dealer banks to set limits on the size of trades and asset positions.
The authors note that banks are particularly likely to rely on stress tests to assess exposures in those asset markets where illiquid conditions and poor historical data make the use of other risk measures difficult.