Stress testing: A new approach for risk management with emphasis on bank's capital requirement

How much capital and liquidity does a bank need to support its risk taking activities? During the recent financial crisis, answers to this question using standard approaches, e.g., regulatory capital ratios, were no longer credible, and thus broad-based supervisory stress testing became the new tool. Stress test investigates banks position in case of a financial crisis and assists supervisory bodies to pass probable financial crisis in future. Bank balance sheets are opaque and susceptible to asset substitution (easy swapping of high risk for low risk assets), so stress tests by openly disclosing details of the results and approaches taken can provide clarity and regain trust that the cost-benefit of stress testing disclosures may lead to more aggregated information instead of bank-specific information. This paper lays out a suggested framework for the stress testing of banks, including how stress testing is done (design and execution) and how their disclosure should be handled in crisis vs. normal times. Furthermore, significance and benefits of stress testing, which has been a popular tool for the regulatory community in the course of the recent financial crisis, are explained.