Bank Stress Testing : A Stochastic Simulation Framework

We present a stochastic simulation forecasting model to stress-test banks' capital adequacy and to estimate probability of infringement of regulatory capital ratios and default probability. The stochastic methodology proposed is based on a simplified reduced model that provides a manageable stress-testing approach based only on those essential variables and key risk drivers that are truly relevant for assessing the bank's capital adequacy, allowing for outputs that can be expressed and analyzed in probabilistic terms. We applied the proposed methodology in a simple stress test exercise on the G-SIBs banks; we performed two stress tests characterized by increasing severity, measuring the banks degree of financial fragility/resilience. The exercise results show sharp differences in the degree of financial fragility of the banks considered