What is a Bank Stress Test?

By Robert S. Siegel
Results of bank stress tests will be released May 7. I have been asked by several readers to write something explaining what the Feds mean by a bank stress test. In keeping with our core principle that a well informed electorate strengthens the Constitution we did some investigation.

Most people are familiar with stress tests from IT or healthcare. Simply defined, we challenge the software or the human body with increasing workloads to see how the software or the body manages the work load. A software stress test means running the software at high usage volumes while it is still in a test mode – we can’t hurt anything outside the test environment. Doctors put patients through stress tests to compare arterial blood flow by having the patient walk on a treadmill while hooked up to monitors to measure results and monitor the patient’s safety.

Before researching this question I did not understand how this could be duplicated by banks when banks are in “live” mode within our economy. The Feds could not actually create credit losses or a drop in real GDP. Thanks to my research I now understand how the tests of the banks are similar to the tests done on software and on the human heart.

The stress tests are run through computer models not a live banking environment. Banks were asked to run projections based on key data on their ability to endure further economic declines. This data included projections of their credit losses and revenues in scenarios encompassing a jump in unemployment, a drop in home prices, and a drop in real GDP. The banks then presented this data along with supporting documentation to the Federal Reserve.

It is important to note that banks that do not perform well on these tests will be required to adjust their capital, to create what is being called a capital buffer, the amount of capital the bank will need to survive a loss due to a downturn. The type of capital, meaning the allocation of the assets the bank must keep is also considered to insure survival. Look for more on that and criticism of the bank stress tests in a later blog.

For further info, Smart Money offers a link to the report by the Supervisory Capital Assessment Program on the Design and Implementation of the tests here. Page 4 has a summary of the test.

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