The depth and duration of the financial crisis has led many banks and supervisory authorities to question the adequacy of stress testing practices prior to and during the crisis. Not only was the crisis far more severe in many respects than was indicated by bank stress tests results, but it was possibly compounded by weaknesses in stress testing practices in reaction to the unfolding events.
Drawing on the lessons for banks and supervisors emerging from the crisis, this paper presents sound principles for the governance, design and implementation of stress testing programmes at banks. It addresses weaknesses in stress testing exposed by the financial crisis, including the specific areas of risk mitigation and risk transfer. The paper sets expectations for the role and responsibilities of supervisors in reviewing firms’ stress testing practices and emphasises that a sound stress testing programme should:
- provide forward-looking assessments of risk,
- complement information from models and historical data,
- be an integral part of capital and liquidity planning,
- support internal and external communication,
- guide the setting of a bank’s risk tolerance, and
facilitate the development of risk mitigation or contingency plans across a range of stressed conditions