The credit crisis and the resulting financial crisis has underscored the importance of stress testing. While most institutions were carrying out stress testing across each risk category, an enterprise wide view of stress testing was not so common. Further, stress testing was carried out on historical numbers using a “point in time” approach. The financial crisis has clearly indicated that this approach is insufficient and a “through the cycle” approach is required based on forward looking statements.
Stress testing is a very important risk management tool for financial institutions. Stress testing alerts institutions on adverse plausible but rare events and their outcomes with insights on additional capital that might be needed to absorb losses should such large shocks occur.