A bank stress test is an analysis conducted under unfavorable economic scenarios which is designed to determine whether a bank has enough capital to withstand the impact of adverse developments. Stress tests can either be carried out internally by banks as part of their own risk management, or by supervisory authorities as part of their regulatory oversight of the banking sector. These tests are meant to detect weak spots in the banking system at an early stage, so that preventive action can be taken by the banks and regulators.
For any financial institution the main issue is to identify the stress test scenarios and to quantify the mathematical probability of occurrence. In practice only the accounting numbers (IFRS) of your company is the measure to calibrate your financial risk management correctly. Only the reverse stress test scenario should be used as the base scenario of your scenario sets. Reverse stress tests are a relatively new stresstest instrument that aims at finding exactly those scenarios that cause a bank to cross the frontier between survival and default. Afterward, the scenario which is most probable has to be identified.
Regarding stress tests and its connection to the Expected Shortfall and Initial Margin calculation a time horizon and its appropriate stress value can be defined by using truncated Lévy flights. See book ISBN: 978-3-95850-864-4 for details.
E.g. the stress scenarios defined within ECB’s stress tests of banks in October 2014 were set
rather randomly and without detailed analysis. Financial institutions’ stress tests are often defined by historical scenarios e.g. 09/11.
Such stress scenarios and the liquidation periods as well as periods of market turmoil, which should define the simulation time horizons are not always captured properly.