What is a stress test?
A stress test is a means for a financial institution to assess its exposure to potential stressors and shocks to the markets. Central banks compel large investment banks to undertake stress tests as part of their regulatory requirements, whilst portfolio managers at investment funds run daily tests to measure risk.
Where have you heard about a stress test?
Stress testing has become increasingly widespread since the 2008 financial crisis. In the aftermath of the crisis, regulators decided that the scenario tests that the banks had been using were not stringent enough. Following the 2010 Dodd-Frank Act, federal regulators required that financial institutions run much tougher stress tests.
What you need to know about a stress test.
Banks and fund managers observe and analyse events from the past such as the October 1987 Wall Street crash, the 1998 Russian debt default and the September 2001 terrorist atrocities. They measure the effects these events had on assets such as bonds, stocks, currencies and commodities and then apply those effects to their current portfolios to gauge their exposure to a similar event happening today. As an individual investor, you too can and should carry out stress tests on your portfolio to measure your own exposure to macroeconomic and other risks.
Find out more about a stress test.
The Bank of England outline their approach to stress testing UK banks here.