In particular, stress testing outcomes for a particular portfolio can provide insights about the validity of statistical models at high confidence intervals, for example those used to determine VaR.Īs stress testing allows for the simulation of shocks which have not previously occurred, it should be used to assess the robustness of models to possible changes in the economic and financial environment. Providing a complementary risk perspective to other risk management tools – Stress tests should complement risk quantification methodologies that are based on complex, quantitative models using backward looking data and estimated statistical relationships. In particular, it should be used to address institution-wide risks, and consider the concentrations and interactions between risks in stress environments that might otherwise be overlooked. Risk identification and control – Stress testing should be included in an institution's risk management activities at various levels, for example, ranging from risk mitigation policies at a detailed or portfolio level to adjusting the institution's business strategy. It should feed into the institution's decision making process, including setting the institution's risk appetite, setting exposure limits, and evaluating strategic choices in longer term business planning.Īn institution's stress testing program should serve the following purposes: A stress testing program as a whole should be actionable, playing an important role in facilitating the development of risk mitigation or contingency plans across a range of stressed conditions. Stress testing should be embedded in enterprise wide risk management. This applies equally to valuation models, models of individual risks and models that aggregate individual risks. Stress testing attempts to determine the impact of situations where the assumptions underlying established models used in managing a business break down. It is also a key risk management tool during periods of expansion, when innovation leads to new products that grow rapidly and for which limited or no historical experience is available. Stress testing is especially important after long periods of benign economic and financial conditions, when fading memory of negative conditions can lead to complacency and the underpricing of risk. Stress testing includes scenario testing and sensitivity testing (refer to Glossary). Stress testing is a risk management technique used to evaluate the potential effects on an institution's financial condition, of a set of specified changes in risk factors, corresponding to exceptional but plausible events Footnote 1.
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