Stress testing is a useful and increasingly popular, yet sometimes misunderstood, method of analyzing the resilience of financial systems to adverse events. This chapter aims to help demystify stress tests and illustrate their strengths and weaknesses. Using an Excel-based exercise with institution-by-institution data, readers are walked through stress testing for credit risk, interest rate and exchange rate risks, liquidity risk, and contagion risk and are guided in the design of stress testing scenarios. The chapter also describes the links between stress testing and other analytical tools, such as financial soundness indicators and supervisory early-warning systems. Furthermore, it includes surveys of stress testing practices in central banks and the IMF.

Contributor Notes

This chapter is an abridged and updated version of IMF Working Paper 07/59 (Čihák, 2007a). The author would like to thank R. Sean Craig, Dale Gray, Plamen Iossifov, Peter Chunnan Liao, Thomas Lutton, Christiane Nickel, Nada Oulidi, Richard Podpiera, Leah Sahely, Graham Slack, and participants in a regional conference on financial stability issues at Sinaia, Romania, and in seminars at the IMF, the World Bank, the Central Bank of Russia, and the Central Bank of Trinidad and Tobago for helpful comments on the working paper; Matthew Jones and Miguel Segoviano for insights on stress testing methodologies; and Roland Straub for help with the overview of stress tests.
Author: Ms. Li L Ong