The balance sheet approach is the “natural” approach to stress testing banks and other financial institutions. The reason is twofold: first, balance sheet information is publicly available for financial institutions in a standardized format,1 which facilitates peer comparison and systemwide stress tests; second, the approach allows a bottom-up view on the vulnerabilities of institutions and hence the identification of important risk drivers. These two dimensions are key advantages of the approach compared with market-based models, which are based on markets’ perceptions of default probabilities and other risk drivers embedded in market prices (such as stock and bond prices and credit default swap spreads), which are not necessarily available for all banks, even in developed markets.

Author: Ms. Li L Ong