What are the main stress testing frameworks used in bank risk management?

Stress testing is a forward-looking risk management tool that evaluates portfolio performance under severe but plausible adverse scenarios. Here are the main frameworks:

1. Sensitivity Analysis (Single-Factor Stress)

Shock one risk factor at a time while holding others constant:

• What if the S&P 500 drops 30%?
• What if the 10-year yield rises 200 basis points?
• What if the USD strengthens 15% against EUR?

Advantage: Simple and transparent. Limitation: Ignores correlation between risk factors.

2. Historical Scenario Analysis

Apply actual market moves from a past crisis:

• 2008 Global Financial Crisis
• 2020 COVID-19 Sell-off
• 1998 Russian Crisis / LTCM

Advantage: Scenarios are internally consistent (all factors moved together historically). Limitation: The next crisis may look nothing like past crises.

3. Hypothetical Scenario Analysis

Design custom scenarios based on current vulnerabilities:

• "What if China invades Taiwan, triggering semiconductor supply disruption, flight-to-quality in UST, and 40% equity correction in Asia?"
• Requires expert judgment to construct plausible factor co-movements.

4. Reverse Stress Testing

Start from a predefined loss threshold (e.g., the firm becomes insolvent) and work backward to identify which scenarios could cause it. This is a regulatory requirement under Basel.

Regulatory Context

Post-2008, regulators (Fed CCAR/DFAST, EBA, PRA) require annual supervisory stress tests with prescribed macroeconomic scenarios. Banks must demonstrate adequate capital under these scenarios.

Example: Ridgeline Financial runs a hypothetical stress test: a 25% equity drop, 150bp spread widening, 50bp rate rise, and 20% oil price decline — all occurring simultaneously over 3 months. The test reveals a $380M pre-tax loss, consuming 120bp of the CET1 ratio.

For the FRM exam, be prepared to compare frameworks and explain why reverse stress testing adds value beyond traditional approaches. Visit our FRM community for more discussions.