Stress Testing
IntermediateStress testing examines how a business, bank or investment portfolio would cope under extreme but plausible adverse conditions, such as a severe recession, a market crash or a sudden rise in interest rates.
Normal forecasts focus on expected outcomes. Stress tests deliberately look at bad outcomes, to check whether an organisation could survive them.
A stress test applies a severe shock to a financial model and measures the results. For a company, that might be a 30% fall in sales combined with higher borrowing costs. For a bank, it might be a deep recession with rising unemployment, falling property prices and many borrowers failing to repay.
For example, a company might find that it remains profitable if sales fall by 15%, but would breach its loan conditions and run short of cash if sales fell by 25%. That knowledge can lead it to hold more cash, reduce debt or arrange backup financing.
Banking regulators in many countries require large banks to run stress tests regularly to show they hold enough capital to absorb heavy losses and keep lending during a crisis. Stress tests do not predict what will happen; they reveal weaknesses so that action can be taken in advance.
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