What is financial Stress testing?

Stress test is a process or simulation technique that evaluates an institutions reaction to different crisis situations. Stress testing and capital planning are increasingly linked to many risk management processes that require coordination across risk, treasury, and financial planning and analysis functions.  Banks have been using stress tests to evaluate their potential vulnerability to certain crisis scenario that would affect the value of their portfolios. The vulnerability is usually measured with reference to the bank’s profitability and /or capital adequacy to respond effectively to various, adverse scenarios.

Traditionally, stress-testing methodology was used with historical information and events, and ascertains what would happen now if we faced the same circumstances again. But this approach has some validity problem as the history may not repeat in identical manner. Now banks in their risk management process generally use computer-generated simulation models that test hypothetical scenarios.  However, some institutions conduct tests using highly customized stress testing methodology.