Why Don't Stress Tests Break Banks?

28 Pages Posted: 1 Jun 2016

See all articles by Kassim Jahn Durrani

Kassim Jahn Durrani

Macquarie University, Macquarie Business School; The University of Sydney

Maurice Peat

The University of Sydney; Financial Research Network (FIRN)

Charles Littrell

Australian Prudential Regulation Authority (APRA)

Date Written: May 31, 2016

Abstract

Despite continued advances in the state of the art, stress tests predict failure less often than would seem reasonable. This paper argues that even if a stress test produces a good estimate for aggregate losses, failing to account for unevenness of losses could easily lead to an under-estimate of likely failures. Instead of relying on mean estimates for residential loan portfolio default rate, LVR and underlying property values, this paper uses distributional properties, providing a more realistic setting by allowing for variation between banks. A key finding is that once such variation is included, the increase in average banking system losses is substantial. Both the average bank and the worst performing group of banks suffer a significantly greater magnitude of loss. A simple intensification algorithm is then presented which allows for stress tests to generate more insight into the likelihood of failure for a given population under stress. The intensification outcomes may well generate a better specified stress model, as the failure patterns brought to light by intensification may reveal better ways to differentiate the stressed population.

Keywords: Commercial banks, Bank regulation, Stress testing, Capital Management, Residential mortgage

JEL Classification: G21, G28

Suggested Citation

Durrani, Kassim Jahn and Durrani, Kassim Jahn and Peat, Maurice and Littrell, Charles, Why Don't Stress Tests Break Banks? (May 31, 2016). Available at SSRN: https://ssrn.com/abstract=2786861 or http://dx.doi.org/10.2139/ssrn.2786861

Kassim Jahn Durrani (Contact Author)

Macquarie University, Macquarie Business School ( email )

New South Wales 2109
Australia

The University of Sydney ( email )

University of Sydney
Sydney, NSW 2006
Australia

Maurice Peat

The University of Sydney ( email )

University of Sydney
Sydney, NSW 2006
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

Charles Littrell

Australian Prudential Regulation Authority (APRA) ( email )

Australia

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