Stress tests: Objectives, challenges and modelling choices

Abstract

Stress tests have become an integral tool for banks’ risk management practices as well as for financial stability assessments by central banks. But there has been no debate about the objectives of stress tests, even though an understanding of those is essential when building and evaluating stress testing models. This paper identifies three main objectives: validation, decision making and communication. And it shows that different objectives lead to different and possibly conflicting priorities for model design. In the light of this discussion modelling choices are assessed and two main challenges for stress testing models are discussed: data limitations and the endogeneity of risk.