Recessions and market crashes are painful for everybody, and they can be especially troublesome for banks. Banks typically lend more money than they have on hand, so bank losses get magnified and ripple through the economy. In an effort to prevent catastrophic outcomes, banks use stress tests to predict what happens when things go badly.
What Is a Bank Stress Test?
A bank stress test is an exercise that helps bank managers and regulators understand a bank’s financial strength. To complete the test, banks run what-if scenarios to determine if they have sufficient assets to survive during periods of economic stress. Stress tests assume that banks lose money and measure the expected effects on bank portfolios over time.
In the U.S., banks use three different sets of conditions to estimate their capital levels: baseline, adverse, and severely adverse conditions. For example, banks might need to model an environment with high unemployment, a housing market crash, and a slowing economy. The Federal Reserve provides the details for stress testing each year by telling banks which specific assumptions to use.
Why Test Banks?
Healthy banks are critical to a functioning economy, and they affect our daily lives. When large banks are a “systemic risk,” they can cause severe widespread harm if they fail, so regulators set rules designed to prevent those outcomes.
The most straightforward model of a bank is that of an institution that takes deposits and lends that money out to other customers. But things have evolved to a point where banks take more risk and use increasing amounts of leverage to improve profits.
During the 2007–2009 financial crisis, financial markets ground to a halt. Large financial institutions failed, and undercapitalized banks couldn’t absorb losses and survive when others defaulted on loans. Those failures caused a chain reaction of increasingly scary events.
Eventually, the U.S. government (and other governments around the world) stepped in to stabilize financial markets. The U.S. government supported several large financial institutions and mortgage-related agencies to help keep the financial system liquid. The result was that global financial institutions became more willing to transact business—helping people, businesses, and governments get the money they needed. What’s more, the FDIC and NCUA both increased deposit insurance amounts from $100,000 to $250,000 to improve consumer confidence and prevent bank runs.
Ultimately, the financial crisis caused turmoil that led to misery for millions of individuals (including job losses, foreclosure, and shattered retirement dreams). Bailout efforts also put taxpayer money at risk, although the U.S. Treasury may have come out ahead after the economy recovered.
Types of Stress Tests
Banks, bank holding companies, and other institutions with more than $250 billion in assets must perform stress tests. The tests required depend on the bank.
Dodd-Frank Act Stress Testing (DFAST)
All banks above the $250-billion threshold must satisfy DFAST by performing company-run tests periodically (annually or biannually, depending on the type of institution) and submitting results to the Fed.
Comprehensive Capital Analysis and Review (CCAR)
Banks with more than $100 billion in assets also need to complete more rigorous supervisory CCAR stress testing. For the largest institutions (over $250 billion in assets), CCAR can include a qualitative aspect as well as the standard quantitative elements. Qualitative examinations include a review of internal bank policies and procedures for dealing with problems, proposed corporate actions, and more.
In an effort to prevent history from repeating, the Consumer Protection Act, also known as the Dodd-Frank Act, took effect in 2010. The act required banks to conduct annual stress tests, though this frequency has since been reduced. Credit unions were not explicitly required to perform stress tests under Dodd-Frank, but the National Credit Union Administration created similar rules to supervise large credit unions.
Impacts of Stress Testing
Stress tests give regulators the information needed to evaluate bank funding and liquidity, and allow them to penalize banks that risk becoming insolvent.
Banks must publish stress test results periodically, so that information is available to the public. As a result, anybody interested in working with financially stable banks can easily identify which banks are strongest. Depositors with deposits that exceed insurance limits can try to reduce the likelihood of losing money by avoiding weak banks.
Regulators can intervene and prevent weak banks from paying dividends to shareholders and participating in mergers and acquisitions. They can even impose fines.
Although it may be an unwelcome exercise, stress testing can be enlightening for bank managers. They understand the impact of challenging economic environments, and they can figure out how to prevent disasters (ideally before they happen).
The Bottom Line
Stress tests are designed to ensure banks are taking the necessary measures to prevent failure in the event of an economic crisis. These tests are ultimately meant to protect the consumers who place their money in the trust of banks, and to stop a financial crisis from quickly getting worse.