Introduction

In the dynamic landscape of risk management, stress testing has emerged as a pivotal tool to assess the resilience of financial institutions and their portfolios under adverse scenarios. This chapter delves into the intricate relationship between stress testing and other risk measures, with a particular focus on its integration within the framework of enterprise-wide stress testing.

Before delving into the relationship between stress testing and other risk measures, it’s essential to recognize the fundamental role stress testing plays in identifying vulnerabilities that traditional risk measures might overlook. While risk measures like Value at Risk (VaR) and Expected Shortfall (ES) provide insights into normal market conditions, stress testing evaluates the impact of extreme events that can lead to systemic disruptions.

Synergy between Stress Testing and Traditional Risk Measures

Stress testing operates synergistically with traditional risk measures such as VaR and ES. While VaR and ES quantify potential losses within specified confidence intervals, stress testing explores the extent of losses during extreme scenarios that surpass historical or modeled data. Stress testing, therefore, complements the limitations of traditional measures by addressing tail risks that might not be adequately captured by regular risk metrics.

Enterprise-Wide Stress Testing and Holistic Risk Assessment

Enterprise-wide stress testing takes the integration between stress testing and other risk measures to a holistic level. It involves assessing how multiple risk factors interact under stress conditions, thereby providing a comprehensive view of an institution’s vulnerabilities. The synergy between stress testing, VaR, and ES becomes evident as they collectively contribute to a more accurate assessment of an institution’s risk exposure.

Example: Consider a financial institution engaged in enterprise-wide stress testing to evaluate its risk exposure across various market segments. While traditional risk measures like VaR and ES might capture market risk to a certain extent, they might overlook the impact of credit risk events on the institution’s overall stability. By integrating stress testing scenarios that simulate credit rating downgrades or defaults, the institution can gauge the combined effect of market and credit risks on its portfolio.