By Dana Yamashita
For people, stress tests can determine how well and how hard their hearts work during physical activity. For banks, a stress test is an indication of how resilient a bank may be when faced with a negative economic shock.
In the United States, banks with $50 billion or more in assets are required to undergo internal stress tests to determine this resiliency. A setback for a bank could come about due to unstable unemployment numbers, inflation, supply and demand events, or a rise in the cost of commodities such as oil — any uncertain or potentially severe risk to funding.
Bank stress tests began after the 2008 recession when the stock market crashed and the housing bubble burst, leading to the failure of some of the largest companies in the U.S.
Raffi E. García, an assistant professor in the Lally School of Management at Rensselaer Polytechnic Institute, has done research that suggests stress tests are beneficial to the banking industry by reducing a bank’s risk and increasing its lending capital. Although stress tests may come with additional costs, increased restrictions, or issues stemming from compliance directives, García’s research found that the overall health of the American banking industry was strengthened.
García also found that investors feel stress-tested banks have a higher probability of earning expected gains and put more money into such banks, making it easier and cheaper for the banks to raise capital.
“Right now, these stress tests are mandatory only for the very largest banks,” García said. “Most of us have our money in banks that aren’t being stress-tested. If you include more banks that comply with these type of transparency requirements, it would be beneficial in protecting taxpayers from future losses.”
The paper, “Stress Testing and Bank Business Patterns: A Regression Discontinuity Study,” was co-authored by Suzanne Steele, an associate at The Brattle Group.