Stress testing financial institutions under macroeconomic shock scenarios

Abstract

The stress testing of financial institutions in macroeconomic shock situations has emerged as a major pillar of contemporary financial stability systems, allowing regulators and banks to measure resilience to the unfavourable economic situation. The paper focuses on the design, implementation, and implication of macroeconomic stress tests and how the shocks are transmitted to the credit risk, capital adequacy, and liquidity positions. The study assesses the impact of severe but realistic macroeconomic events on institutional and system-wide stability with the help of a mixture of deterministic and stochastic scenario modeling. The analysis also puts a great deal of emphasis on incorporating the effects of dynamic feedbacks, tail-risk, and structural vulnerabilities to enhance the predictive ability of stress tests. The results can be used by the policymakers, supervisors, and financial institutions to act upon and improve their risk management to protect the stability of the systemic factors and better preparedness against economic breakdowns in the future.