Comparison of stress tests

Stress testing and shocks to the economy were important issues in Bank of England's "Financial Stability Report, Issue No. 20", which was published in July 2006. The report includes detailed information about Bank of England's stress testing methodology.

Danske Bank has compared its stress testing methodology with Bank of England's. The main conclusion is that the methodologies are very similar. The following tables present the highlights of the comparison.

Stress testing: Step by step

Step	Bank of England	Danske Bank
Start	Identifying systemic vulnerabilties	Identification of key risk drivers
I	Construction of stress scenarios	Choice of scenario
II	Mapping transmission channels to banks	Translation of scenario
III	Measuring risk transmission channels	Stress test calculation
IV		Assessment of results and approaches

Bank of England uses two macroeconomic scenarios

• Recession in line with the situation in 1990
  Adverse condition/event affects the supply side negatively. This leads to increasing interest rates and inflation. This scenario is similar to Danske Bank's scenario labelled "Recession (1 in 25)"
• Fast global increase in interest rates and risk premiums
  Similar to Danske Bank's scenario labelled "Falling property prices"
  
  

Stress testing: Estimation of five important risk types

Risk type	Bank of England	Danske Bank
Credit	Linear regression based on historical loss data	Linear regression based on historical loss data
Market	Publicly available VaR numbers	The effect of the scenario is imbedded in Step III: Translation
Income generation	Linear regression (partial)	Linear regression
Funding	Expert opinion: Quantifying the effect of a rating downgrade	Expert opinion: Quantifying the effect of a rating downgrade
Operational	Expert opinion: Quantifying the effects of a breakdown in trading systems	Expert opinion: % deviation from base case

Important views on stress testing
Bank of England highlights two important issues regarding stress testing

• Stress testing should play a central role in risk management and in setting a bank's risk appetite
• It would be beneficial to construct a number of standard scenarios which all institutions in the sector should apply
  
  

Last updated/revised on August 9, 2007