Stress Testing

The purpose of stress testing is to analyze how credit risk models behave under adverse internal or external circumstances. This chapter discusses various ways of stress testing such as sensitivity-based stress testing, historical scenario-based stress testing, and hypothetical scenario-based stress testing. Stress testing has to be interpreted in conjunction with the portfolio risk model and related level of conservatism as capital is assigned to higher percentiles of the portfolio loss distribution. The chapter also discusses the capital allocation under the Basel regulation and stress testing. It explains the Berkowitz critique and shows how stress testing and bank capital are related. In light of the presence of a risk model and the Berkowitz critiques, stress testing results in capital increases only if a stress test produces a more severe outcome than the risk model. Finally, the chapter explains the uncertainties considered by a bank in its stress testing analysis: scenario stress testing and parameter uncertainty.