Stress Testing: An extraordinary balancing act

The IMF held an unofficial discussion yesterday morning on what the financial crisis has taught us about stress tests. (The discussants were very clear—none of the views expressed at the meeting represent the official views of the IMF. The same is true of the summary here.) 

The conversations highlighted the delicate balance that such tests need to achieve. When creating the parameters for these tests, how do we "think the unthinkable", while still adopting reasonable parameters that provide credibility? How do we decide if a 25 percent exchange rate depreciation is enough, or if 50 percent is too much? How do we design a scenario that is exceptional, but plausible?

Take, for example, the most spectacular banking system collapse of the entire crisis: Iceland. A case study of Landsbanki Islands, the country's second largest bank, applied the following stress test criteria:

1. 35% fall in domestic stock prices, 25% fall in foreign stocks;
2. 20% loss in the value of non-performing loans;
3. 7% fall in bond prices; and,
4. 20% depreciation of the Krona

Under these harsh circumstances, Landsbanki actually remains solvent. In order to produce insolvency, the stress test would need to include a run on bank deposits, which is what ended up happening to 40 percent of Landsbanki's U.K. Icesave accounts. Keeping in mind that hindsight is 20/20, how would such a sitution have been envisioned, particularly in an economy that, at the time, was being celebrated as one of the world's most dynamic?

Applying rigorous tests to vulnerable economies is no less easy.  

While stress tests can serve as an important mechanism for banks and financial systems to protect themselves from the effects of future crises, they are too often shunned by the institutions that need them the most. These institutions fear that applying hypothetical scenarios that "imagine the unimaginable" will create a self-fulfilling prophecy, whereby the results can lead to a drop in confidence in the institution's financial health and a run on deposits. The stress test will end up creating the worst case scenario that it had imagined. 

Look ahead to much discussion about what an ideal stress test would look like, and how it can be used by those who need it most.