Definition

• A computer simulation technique used to test the resilience of institutions and investment portfolios against possible future financial situations.
• Helping gauge investment risk and the adequacy of assets, as well as to help evaluate internal processes and controls.

E.g: 

• What happens if unemployment rate rises to v% in a specific year?
• What happens if equity markets crash by more than w% this year?
• What happens if GDP falls by x% in a given year?
• What happens if interest rates go up by at least y%?
• What if half the instruments in the portfolio terminate their contracts in the fifth year?
• What happens if oil prices rise by z%?

Types of stress testing

Among the most popular are stylized scenarios, hypotheticals, and historical scenarios.

• In a historical scenario, the business is run through a simulation based on a previous crisis. 
• A hypothetical stress test is generally more specific, often focusing on how a particular company might weather a particular crisis.

• Stylized scenarios are a little more scientific in the sense that only one or a few test variables are adjusted at once. Monte Carlo simulation is one of the most widely known. This type of stress testing can be used for modeling probabilities of various outcomes given specific variables, for example, various economic variables.

Bank stress testing

Definition

• An analysis conducted under hypothetical unfavorable economic scenarios, such as a deep recession or financial market crisis;
• Designed to determine whether a bank has enough capital to withstand the impact of adverse economic developments.

How it’s conducted

• To determine banks’ financial health in crisis situations, stress tests focus on a few key areas, such as credit risk, market risk, and liquidity risk,  based on an examination of the balance sheet of that institution.
• Using computer simulations, hypothetical crises are created using various criteria from the Federal Reserve and IMF.
• The ECB also has strict stress testing requirements that cover approximately 70% of the banking institutions across the eurozone.
• Company-run stress tests are conducted on a semiannual basis and fall under strict reporting deadlines.

Content source: 
1. Kenton. W. (2020) Stress testing. Available at: https://www.investopedia.com/terms/s/stresstesting.asp [Accessed on Apr 15, 2020]
2. Segal. T. (2020) Bank Stress Test.Available at: https://www.investopedia.com/terms/b/bank-stress-test.asp [Accessed on Apr 15, 2020]