Finance minister asks public banks to take stress tests; what are these?

Bank stress tests were introduced after the 2008 financial crisis, and they revealed the vulnerability of banks to market crashes and economic downturns

In the wake of the collapse of several banks like Credit Suisse and Silicon Valley Bank, finance minister Nirmala Sitharaman in a meeting, told the chiefs of public sector banks that they must stay alert, take stress tests and frame detailed crisis management strategies.

The bank chiefs told Sitharaman that they are vigilant of the global banking sector developments and taking all possible steps to safeguard themselves.

What is a bank stress test?

The bank stress test is an analysis conducted by banks under hypothetical situations to check if they have enough capital to withstand an adverse economic situation like a market crash. The balance sheet of the banks is analysed by assuming the values of economic variables as they might be in case of a recession, high unemployment or some other stressful situation.

Due to the presence of several variables, conducting a stress test is a tedious job for banks. But the central banks provide a basic framework for running such tests. The key stress areas focused on are liquidity, market, and credit risks.

History of bank stress tests

These tests were introduced after the 2008 financial crisis. It revealed the vulnerability of banks to market crashes and economic downturns. It was also identified that some institutions that are too big to fail might cause a contagion if they go down.

So, the regulators developed the stress test to prevent any such collapse in future.

What benefit does a bank stress test offer?

This test helps the banks in risk management. Banks that fail the stress test must build up their capital reserves. The banks may also be asked to cut their dividend payouts and share buybacks to preserve their capital.

Moreover, the result of these tests is also revealed to the public to maintain transparency.

Are there any criticisms of the bank stress test?

Yes, some critics have said that stress tests are overly demanding. According to many, these tests force the banks to retain too much capital. Some have even blamed these requirements for the slow pace of economic recovery after the 2008 crisis.