In the past few years of the recent financial crisis, you’ve heard the news and media cover stories on banks that have to undergo “stress tests”. However, you may have no clue as to what bank stress tests entail.

Upon hearing “stress test”, you may think of a patient at a hospital, who has to perform strenuous activity to observe the heart’s health, or a shopper at a furniture store, who puts pressure on a chair to demonstrate its durability. These stress tests are examples of physical forces. So how do you stress test a bank?

Putting Banks in “Fake” Distress

Bank stress tests can be carried out by banks themselves for risk analysis purposes or by federal regulators to serve as prognostic economic assessments. The entire concept of a bank stress test is to place the bank in a tough position. In reality, it simply involves evaluating a financial institution under various scenarios.

What if the unemployment rate jumped? What happens if the Dow Jones Industrial Index fell 10%? How would an increased rate of defaults affect the bank? Could the bank remain in operation if customers withdrew 20% of the deposits?

Along with the many different factors used in stress test scenarios, there are also many ways to examine the results.

For example, given that the home prices fell 20% in the next 12 months, individual banks wouldhave to examine their institution’s risk in the mortgage market and mortgage rates in general. From a macroeconomic perspective, the Federal Reserve will need to assess how a national foreclosure crisis can influence the global economy. With a microeconomic scope, banks and the government can evaluate how such a housing crisis will change the supply and demand of mortgage loans, which will directly impact the banking system.

What Stress Tests Reveal

It may sound like playing “make believe” on a large scale but stress tests can uncover a wealth of information regarding a banks liquidity, credit, and market risks. Additionally, U.S. officials can analyze the relationship between the economy and the financial system while identifying problems areas that require attention.

If a weak spot in the bank or the economy presents itself, the banks and the appropriate government agencies will know what needs to be fixed and how they should go about fixing it. Preventative measures can be taken to avoid economic catastrophes in the event that these imaginary, yet realistically possible, scenarios come true.

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