Stress testing
Explore conditional vulnerability under adverse scenarios
Stress testing projects outcomes under specified adverse conditions. Sensitivity tests vary particular drivers; scenario tests combine coherent shocks; reverse stress tests ask what conditions would cause a defined failure. Banking applications connect macroeconomic or market changes to losses, income, liquidity and capital. The exercise is conditional on assumptions and does not assign a probability unless a separate probability model is supplied.
Choose this for vulnerability assessment when rare adverse states are poorly represented in observed data. It requires an explicit exposure model and a defensible account of how shocks transmit through the system.
Strengths
- Explores adverse states beyond a short historical sample
- Makes transmission mechanisms and management assumptions inspectable
Limitations
- Results depend strongly on scenario and balance-sheet assumptions
- Feedback, contagion and behavioural responses are difficult to model
Know the boundary
A stress scenario is not a forecast and its severity is not its probability.