Stress Testing - An Introduction

Value at risk (VaR) techniques have been a mainstay of financial risk management since the 1990s. If a bank uses a 99% confidence level to calculate its value at risk, it generally expects to suffer a loss exceeding the VaR on one day out of every 100. What happens, however, on the one day when the VaR is exceeded? How large is the loss on this day? Could this be the one bad day required to ‘break the bank’?


The criticisms that VaR was poor at estimating risk under non-normal conditions were seen as somewhat academic during the benign financial conditions of the early years of the century. However, there has always been an understanding of the need to go beyond VaR methods in order to gain a more holistic view of risk exposures. By its nature, stress testing compels risk managers to assess linkages between events and to more fully understand the nature of risk exposures.


The global financial crisis damaged the reputation of some risk measurement techniques, including stress tests. However, the response has been not to abandon stress testing but instead to strengthen and extend it. This course describes how the practice of stress testing has developed within financial risk management in recent years and highlights its growing importance following the events of the crisis. It also addresses the different types of stress test in terms of both institutional and regulatory contexts.


    On completion of this course, you will be able to:

    Explain why there has been increased focus on stress testing as opposed to value at risk (VaR) in recent years

    Outline how a stress testing program is implemented

    Describe the typical stress testing 'best practices' expected by regulators and the specific stress testing requirements imposed by regulators


    Topic 1: The Need for Stress Testing

    Problems with Value at Risk (VaR)

    VaR & Stress Testing – Complementary Approaches

    Topic 2: Stress Testing Programs

    Definition of a Stress Test

    Sensitivity Analysis vs. Scenario Analysis

    Types of Stress Test

    o Internal

    o External – Specific Supervisory

    o External – Macroprudential

    Stress Testing Scenarios

    o Historical vs. Hypothetical

    o Top-Down vs Bottom-Up

    o Relevant & Actionable

    Reverse Stress Testing

    Incorporating Complex Products/Risks

    Computational Issues

    Stress Testing Burden

    Topic 3: Best Practices and Regulation

    Best Practices

    o Personnel

    o Coverage/Scope

    o Infrastructure


    Capital & Risk

    o Pillar 1 Stress Testing

    o Pillar 2 Stress Testing

    Liquidity Concerns

    o Liquidity Stress Testing

    • Liquidity Coverage Ratio (LC)

    • Net Stable Funding Ratio (NSFR)

    System-Wide Stress Testing

    o US Banks

    o European Banks



    75 Minutes

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