In this course we discuss stress testing. What is stress testing?

Stress testing is a procedure used by banks to verify if their capital allocations (regulatory capital and economic capital) are sufficient to cover them against extreme but plausible events.
This is important: banks want to verify if they are able to bear the risk of events that are uncommon, large, “extreme” (in their definition), but yet plausible, that is with a non-negligible probability of occurrence.
Those working in extreme value theory surely do not agree with this definition and approach, but this is what banks do.

Stress testing is becoming very important for banks.
A point of criticism of Basel II was in fact that most of the models used by banks assumed normality, underestimating the probability of uncommon events. Thanks to stress testing, Basel III tries to give a first answer to the request of a more realistic modeling.
Is it enough? Probably no, but still better than nothing.

[Little digression: If you ask me about my opinion, I am pretty sure that sooner or later a serious modeling of extreme events will be essential in risk management. The statistical tools are already there, we simply need to use them.]

We will see that stress testing is based on scenario analysis.
Every bank is supposed to develop scenarios about future trends in the markets, often assuming very bad economic conditions. On the basis of those scenarios, using computational tools such as Monte Carlo simulations, banks test their resistence and the adequacy of their capital.
In the EU, banks are supposed to regularly pass a stress test imposed by the regulator (the last one in 2014), using some specific scenarios. But this is not the same everywhere.

In this class we will also consider stressed measures of risk. In particular we will introduce the Stressed VaR, as a way of taking into consideration the possibility that the losses we have observed so far are not completely representative of what is yet to come.
In the Stressed VaR approach, we compute our VaR just on the largest losses, as if we expect that things are getting worse and worse.

However, there is no need to be stressed. Just relax and enjoy this new lecture. 😉