As the world is crawling out of the global economic crisis, several efforts are underway by regulators as well as international organizations, such as the International Monetary Fund (IMF) and Bank of International Settlements, to institutionalize stress testing as an integral part of the bank’s functioning. The intent is to better understand system-wide risks that can trigger widespread economic and financial instability. US Fed, therefore, has mandated an annual Comprehensive Capital Adequacy Review (CCAR) exercise for all banks to submit their capital plans for multiple scenarios (baseline and stressed scenarios).
However, the road to implementing these methodologies is not as smooth. We often get asked about: Which stress-testing method should be used? Which system would pass muster with the regulators? What level should we stress at – loan, cluster or portfolio level? In this paper, we have attempted to highlight the different types of stress testing methodologies and their advantages / disadvantages. The objective is to share our perspectives on different methodologies and equip the reader with working knowledge of the same.