Stress Testing

Joseph Breeden

Stress testing was first developed in engineering. Aeroplanes, cars, buildings, ships, power grids and more all go through stress tests during design and construction to make sure they can withstand a plausible range of stressful events. A stress test revealed that the Citibank tower in Manhattan was vulnerable to severe damage in a hurricane, so remedial action was taken and a possible disaster was averted (Morgenstern 1995). Stress tests in New Orleans showed that the levees were vulnerable to breach in a severe hurricane (Walsh 2006) and that the stress tests previously created during the levee design used hurricanes that were not severe enough (Schwartz 2006). Unfortunately, the designs were not improved and the planned repairs were too slow and insufficient – leading to the 2005 Hurricane Katrina disaster (van Heerden 2007). Starting in 2009, the banking world changed and stress tests are likely to have become a permanent part of lending.

Many things have been called stress tests through the years, but the assumption here is that stress testing involves correlating historical macroeconomic data to portfolio performance, creating an extreme macroeconomic scenario and