Stress Scenario
A stress scenario is a hypothetical adverse economic or financial situation used to assess the resilience of financial institutions.
Meaning in Practice
In practice, regulators or banks design stress scenarios that include severe recessions, market crashes, or sharp interest rate movements. These scenarios are applied to balance sheets and income projections to estimate potential losses. The objective is to evaluate capital adequacy and liquidity under extreme but plausible conditions.
Why It Matters
Stress scenarios help identify vulnerabilities before real crises occur. They strengthen risk management and support forward-looking supervision. Effective scenario design improves preparedness and systemic resilience.
Market Impact
Results from stress scenarios can influence investor confidence and bank valuations. Weak outcomes may lead to capital raising or dividend restrictions. Strong performance typically supports market stability.
Example
A supervisory authority models a severe recession with rising unemployment and falling property prices to assess how banks’ loan portfolios would perform under significant economic stress.