What Is Involved in Stress Testing for Financial Institutions?

Stress testing for financial institutions involves concocting hypothetical situations that reveal how the institutions would respond in a series of worst-case scenarios. There are times when stress testing is done by an institution to test its readiness for the possibility of a sudden event that negatively impacts business. On other occasions, stress testing for financial institutions may be ordered by a government to prevent the collapse of large institutions that would significantly harm the economy at large. One of the key goals of stress testing is to indentify toxic assets that may improve an institution's bottom line but don't really have much actual value.

Measuring the financial health of an institution when the economy is running smoothly and there are no overwhelming problems is useful, but it may not show how that institution would react to sudden, unforeseen pressures. These pressures can be brought about by some cataclysmic world event, a sudden economic downturn, or some internal stress that affects the institution specifically. In times like these, certain companies and institutions will sustain and others will crumble. Performing stress testing for financial institutions will determine to which category an institution belongs.

When performing stress testing for financial institutions, it is important for analysts to come up with scenarios that actually reflect what could realistically happen. In this way, stress testing is an effective method of risk assessment. The hypothetical scenarios are usually run by computer programs that use existing financial data to determine how an institution would be affected by these unfortunate events.

In difficult economic times, it might be necessary for governments to do stress testing for financial institutions that operate on the highest levels. Banks and insurance companies, upon which so many members of society rely for funding in their own difficult times, must be able to show strength even at an economy's lowest ebb. For that reason, a government may perform stress tests on these institutions to ensure that damage in poor economic times will be limited.

Toxic assets must be identified by those in charge of executing stress testing for financial institutions. If such assets, whose actual value is far less that their stated value, are being used as collateral for debt obligations, the consequences could be catastrophic. Financial stress testing must evaluate all of the possible weakness in an institution's entire portfolio of assets. By exposing where an institution is most vulnerable, stress testing can provide the pathway to necessary improvements and corrections.