Bank Stress Test Analysis - Thesis Example

Several large banks began using internal stress tests in the early 90s to determine the ability to respond to market needs, events, and sentiments. However, stress tests were usually performed by banks for their internal assessment in the early and late 90s. Things started to change thereafter when the government of different countries started taking an interest in ensuring effective operations of financial institutions in the volatile financial environment.

Stress tests have been regularly performed by financial regulators to ensure that banks are performing as per the required standards. Regular stress tests have been proposed by several governments across the world and the UK is no more an exception. The Financial Policy Committee has proposed that regular stress tests should be conducted on every bank to assess capital adequacy along with financial limitations and constraints in a critical manner. Several researchers stated that the reason behind conducting stress tests is based on the notion that the financial crisis in the past has affected the positive operations of financial institutions resulting in heavy losses. To mitigate such losses and uncertainty, it is important to conduct stress tests regularly. The major purpose of this thesis is to thematically address the methods, application, and critical appraisal along with ascertaining that the stress test that European Union performs is an adequate means to test banks for their crisis safety.

Acharya, et al (2007) stated that stress testing has been preferred by several financial regulators for assessing the risk framework in a well-planned manner. It needs to be mentioned that stresses are normally in the form of sensitivities like a price drop, rises in volatility, spreads double, and scenarios like Black Monday, Lehman Bankruptcy, and severe financial recession. These kinds of stresses are normally found in the financial environment, especially in trading operations. On the other hand, non-financial risks in the form of operational risks, business risks, and reputational risks are hard to ascertain and quantify. It is often believed that these stresses are normal for financial institutions resulting in the financial assessment. Allen, et al (2004) believed that risk management has been an important aspect of the financial environment and stress testing both scenario and sensitivity based have been mentioned and discussed in the risk management literature. Stress testing as a risk management discipline has been closely found and discussed in the data-rich environment of the trading environment.

Gibson and Mosser (2001) researched stress testing and pointed out that most of the scenarios are related to shock to market rate, interest rate, volatilities, and market prices. General examples are share market crash, debt market fall, and recessions. Such scenarios are easy to understand and analyze. Furthermore, these scenarios are transparent and easy to understand and analyze in terms of financial risk. Flannery (2012) pointed out that several scenarios can affect stress testing. Furthermore, stress testing involves several steps that need to be analyzed systematically and critically. Foglia (2008) stated that market risk stress tests have been a new addition to the stress tests in the last few years focussing on market risk and factors. This is a lengthy assessment of risk factors that may take a good amount of time. Thus, stress testing may be cumbersome and time taking resulting in general or specific results that may help in ascertaining the financial condition of the financial institutions.

The Financial Policy Committee (FPC) last year recommended that the Bank and Prudential Regulation Authority (PRA) should formulate and execute proposals for regular and systematic stress testing of UK banks. The major purpose of stress testing is to offer a quantitative assessment of capital adequacy and requirement in the UK banking system and institutions associated with them.