Stress testing bank profitability

Abstract

A defining difference of macro-style stress testing is the explicit consideration of profitability dynamics in the stress scenario. Traditional stress testing had focused almost exclusively on losses only, but a complete assessment of capital adequacy under stress must take into account not just the balance sheet but also the income statement. For instance, in the 2013 US stress test, reduction in projected income for the 18 mandatory bank holding companies (BHCs) covered nearly 60 per cent of projected stress losses. This paper describes and discusses a framework for modelling the major components of the income statement for BHCs using the US regulatory reports as an empirical illustration. It reviews approaches taken by the industry and traces the remarkable development in the wake of the financial crisis. The findings — perhaps unsurprisingly and in line with previous literature — show that successfully modelling profitability requires a tailored BHC-specific approach to revenue segmentation and modelling. The paper argues that failure to pursue a relatively granular income source segmentation along different business activities, far more granular than reflected in typical regulatory reports, will obscure significant underlying differences in macro risk factor sensitivities.