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Stress Testing - A Key to Open Banks' Pandora's Box

The onset of financial crisis in 2008 was mainly due to aggressive positions taken by the financial firms in complex financial instruments. Moreover these financial instruments, in which positions were taken, turned out to be illiquid at the time of stress. Insufficient capital and illiquid assets held by banks were the main reasons for these banks failing to avert the financial crisis. Since then, various regulations have been passed asking banks to risk weight the assets they hold, maintain certain minimum capital as a percentage of their risk weighted assets, hold certain minimum amount of assets which are highly liquid as a percentage of their cash outflows (short term and long term), report all their OTC derivatives trades and mandatorily clear these trades via a Central Counterparty. However, complying with these regulations in a stable financial environment wouldn’t give a clear picture whether these banks are safe to carry out their activities even in the time of a crisis. Hence, the Federal Reserve has decided to carry out the so-called “Stress Tests” at these banks, wherein the banks financial health would be tested under various economic situations. This paper explains the stress tests scenarios conducted under various economic scenarios by the Federal Reserve as a part of the Dodd Frank Act.