Give an example of regulatory stress testing and describe what reverse stress testing is.
The idea
A standard example of regulatory stress testing is the US Federal Reserve programme (CCAR and DFAST). Large banks project losses and capital over a multi-quarter horizon, about nine quarters, under supervisor-provided scenarios, typically baseline, adverse and severely adverse. They use their own models on the same scenarios, so results are comparable and capital adequacy can be judged. European supervisors run similar EU-wide exercises. Reverse stress testing turns the process around. Management first defines an unacceptable outcome, such as insolvency, a breach of minimum capital or exhaustion of liquidity, and then searches for the scenarios and combinations of events that could produce it. Its value is that it is not anchored to the scenarios already imagined, so it exposes hidden vulnerabilities and concentrations. The usual error is to confuse direction. Ordinary tests go from scenario to loss, and reverse tests go from loss to scenario.
A practice question
Which is an example of regulatory stress testing?
- The US Federal Reserve's CCAR and DFAST exercises, in which large banks project capital under supervisory scenarios. - correct
- The Basel traffic-light approach, in which VaR exceptions are counted against actual profit and loss over the latest 250 trading days.Why not: This is backtesting of VaR, not a stress test of capital under scenarios.
- A bank's own daily monitoring of trader VaR limits by an independent risk team.Why not: Internal limit monitoring is not a regulatory stress test.
- A rating agency's annual credit review of the bank's senior debt.Why not: A rating review is not a supervisory stress testing programme.
In the US, supervisory stress tests (CCAR and DFAST) require large banks to show that capital would remain adequate over a multi-quarter horizon under scenarios provided by the Federal Reserve.
A harder one
A bank has Common Equity Tier 1 capital of USD 45 billion and risk-weighted assets of USD 400 billion. It regards a CET1 ratio of 6% as the failure point. In a reverse stress test, ignoring any change in risk-weighted assets, what loss would bring the bank to that threshold?
- USD 24 billionWhy not: This is the capital needed at the threshold (6% x 400), not the loss that reduces capital to it.
- USD 5.25 billionWhy not: Takes the gap between the current ratio of 11.25% and 6%, 5.25 percentage points, and reads it as USD billion.
- USD 21 billion - correct
- USD 39 billionWhy not: Subtracts the 6% threshold figure directly from capital as if it were USD 6 billion.
Capital at the threshold = 6% x 400 = 24. Loss needed = 45 - 24 = 21 (USD billion). The reverse test fixes the failure outcome and solves for the loss.
The hardest tier
Which statement correctly contrasts a supervisory stress test with a reverse stress test?
- In the supervisory test the outcome is fixed and the scenario is the unknown; in the reverse test the scenario is fixed in advance and capital is the result.Why not: This reverses the two directions.
- The supervisory test fixes the scenario and outputs the capital result; the reverse test fixes the failure outcome and solves for the scenario. - correct
- In both tests the scenario and the outcome are fixed in advance, and only the probability is estimated.Why not: Neither exercise fixes both and estimates a probability; one fixes the scenario, the other the outcome.
- Reverse stress tests apply only to market risk, while supervisory tests apply only to credit risk.Why not: Both can span risk types; the distinction is the direction of the analysis, not the risk type.
Supervisory tests run forward from a given scenario to a capital result. Reverse stress tests start with the unacceptable result and work backwards to find what could produce it.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
Start free →More in Stress Testing
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