Stress Testing involves testing a model or a system under extreme or unfavorable situations, circumstances that fall outside normal events, to assess the impact on results and returns.
This exercise is done to come up with a more robust model in the physical world, and is used to determine capital requirements for multiple risk factors in the financial services world.
Regulators require management teams and board members to use Stress Testing to better plan and prepare for unexpected situations that may arise in the future.
Today stress testing using a combination of techniques. Review of historical data to identify worst case shocks, extreme movement scenarios, probability of shortfall and ruin as well as breakdown of correlation structures in asset classes and combining all of the above in one massive stress test. The primary focus is on answering a handful of questions. What would it take for this bank to fail? How would we fare if the past repeated itself? How strong is our balance sheet and our capital? How much more capital would we need?
Post the financial crisis the Federal Reserve runs a stress test on major banks to ensure the stability of the banking system in case of a repeat of conditions that led to the collapse of Bear, Lehman, Citi and AIG.