Stress tests assess the likelihood of a bank losing its capital in a prolonged, highly adverse economic environment. In doing so, they also determine how much of its capital the bank can use as a cushion against any potential losses. This helps regulators and authorities evaluate a bank's ability to withstand and manage losses, which could impact the stability, liquidity and soundness of the financial system.

There are two types of stress tests: micro- and macroeconomic. The microeconomic stress test measures the impact of a particular stressor or event on a bank’s individual balance sheet. Examples of microeconomic stress tests include tests of liquidity and reserve requirements, capital requirements tests and credit risk tests.

Macroeconomic stress tests, also called forward-looking stress tests, assess the impact of market-wide and macroeconomic scenarios on the financial health of a bank and its individual loans, securities and credit portfolios. They measure the capital levels associated with economic downturns and other stresses. Examples of macroeconomic stress tests include economic scenario stress tests and liquidity stress tests.

Stress tests are conducted on both a qualitative and quantitative level. Qualitative assessments measure a bank’s management policies and procedures along with the strength of its corporate governance. Quantitative tests measure the effects of the hypothetical stressor on the balance sheet of the bank and its individual loans, securities and credit portfolios.

The actual stress test is based on a number of assumptions. This includes the severity and duration of the stress scenario, the size of potential losses and the amount of capital to be set aside to absorb the potential losses. The results of a stress test are reported to senior management and external regulators, who will then use the information to assess the ability of the bank to withstand potential losses and to understand the potential capital adequacy needs of the bank.

In conclusion, stress tests provide the financial authorities and senior bank management with crucial insights into how the bank is faring financially and how it may respond to turbulent economic times. By assessing the potential impact of stressors, authorities can identify issues before they become serious problems and may also provide feedback to the bank on any changes that need to be made to its risk management processes.