DEVELOPING STRESS TESTING AS RISK-MANAGEMENT PRACTICES

Stress testing is an appealing risk-management tool because it provides risk managers with additional information on possible portfolio losses arising from extreme, although plausible, scenarios. In a volatile financial environment, stress tests have recently become more important as an instrument to gauge the impact of specific adverse developments in the economy. Stress testing may be increasingly used by financial firms for both internal and external purposes. This Article offers a conceptual framework for defining stress testing, describing its possible applications, highlight certain techniques developed to conduct this testing including a few methods for identifying stress scenarios and survey its recent use by supervisory agencies. The usefulness of stress tests as risk management tool crucially depends on the choice of stress scenarios: if the scenario is too implausible, the stress test results will be ignored by management. There is no generally accepted standard how to choose scenarios. Many institutions apply some standardized scenarios derived from extreme market moves in the past. In addition, stress scenarios can often be an effective communication tool within the firm and to outside parties, such as supervisors and investors.