Recently released European Banking Authority (EBA) stress test results have many banks breathing a sigh of relief and some banks feeling a world of pain. While stress tests like this one are certainly helpful when it comes to easing fears about a future financial crisis, many investors have no idea what it means for a bank to “pass” or “fail” a stress test.
How does a stress test work?
In general, the idea behind a stress test is to determine if banks (or other institutions) have adequate capital levels to safely survive a downturn in economic conditions. Regulators typically look at banks’ “capital ratios,” which are measures of how much of a bank’s finances come from internal sources, such as operational cash flows and shareholder funding, versus how much comes from borrowing from outside sources. During times of financial uncertainty, outside financing can become unreliable, and if banks do not have adequate internal capital available, they run the risk of becoming insolvent.
United States SCAP and CCAP Tests
The first stress test that came about as a result of the 2008-2009 U.S. financial crisis was the 2009 Supervisory Capital Assessment Program. This initial stress test was conducted by the Federal Reserve, and it looked at the financial strength of 19 of the largest U.S. banks under two different scenarios.
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