Stress tests and the financial system

March 14, 2012

A post by Kim Schoenholtz

For decades, financial institutions have used stress tests to assess their well-being. These tests usually simulate the performance of one bank in a scenario that could make it illiquid (unable to sell assets or to borrow) or insolvent (liabilities exceed assets). Until recently, however, typical test scenarios were far less challenging than the actual experience of the financial crisis that began in 2007.

Now, financial regulators in the United States and Europe routinely employ stress tests as a tool to limit the likelihood and severity of another crisis.  This week, the Fed released its 2012 test results (the Dodd-Frank law requires an annual test), while the new European Banking Authority (EBA) is expected to conduct its second test in 2013.

Recent research on stress tests focuses on how to make them more effective both in crisis prevention and mitigation. This work highlights the importance of assessing the financial system as a whole (including the interaction between institutions), rather than the wellbeing of individual intermediaries. It emphasizes both capital adequacy and liquidity considerations, requiring attention to both the asset and liability sides of intermediary balance sheets. And it underscores the need to ensure a mechanism (preferably through private funding) for adding capital to financial systems facing a shortfall.

My op-ed with Anil Kashyap and Hyun Shin applies these “macroprudential principles” to the challenges facing the EBA in its next stress test. It also comments on the Fed’s decision to approve larger disbursements of capital from the US financial system despite the euro-area crisis.

Update:  related piece by Anat Admati.

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