What is the Bank Stress Test and its importance?

What is the Bank Stress Test?

Bank stress testing is a framework for analyzing the financial impact of unfavorable economic scenarios to ensure that banks have sufficient capital to maintain operations during economic crisis situations.

Why is it required?

The stress tests are required to make sure banks are prepared for whatever economic crisis might be right around the corner. Stress tests also force banks to play it safe by maintaining financial cushions against losses, and they serve as a form of accountability among large institutions. Healthy banks are critical to a functioning economy, and they affect our daily lives. When large banks are a “systemic risk,” they can cause severe widespread harm if they fail, so regulators set rules designed to prevent those outcomes.

The most straightforward model of a bank is an institution that takes deposits and lends that money out to other customers. But things have evolved to a point where banks take more risk and use increasing amounts of leverage to improve profits.

Bank stress testing required by the regulation include:

CCAR and DFAST by the Federal Reserve
EU-wide stress testing by the European Banking Authority
Annual industry stress test by the Bank of England

What are the impacts of the Stress Test on Forex?

When banks are opening an office in another country the stress will start on the exchange rate. If the exchange rate is low ((i.e) home currency is less than other currency) the bank may face some risk. It also depends on the interest rate of the other country too. Again, the correlation may be very small in a normal scenario but could become very high in a stress scenario. Therefore, this link must be modeled carefully in the context of a stress testing exercise.

FX rates can have a big impact on liquidity. Most of the reports required by the different supervisors now have to be produced per currency, as there is a difference between having cash in local currency and the US dollar. Even when the exchange rate is indexed on the dollar, some differences can appear when a crisis occurs. It is therefore very important to calculate two metrics in each currency. Even for liquid currencies, it is not always easy to exchange one currency for another.