Since models cannot incorporate all possible risk outcomes and generally are not capable of capturing “event risks” and sudden / dramatic changes, banks need to supplement models with “stress tests”. Internationally, stress testing has become an integral part of banks’ risk management systems and is used to evaluate the potential vulnerability to certain unlikely but plausible events or movements in financial variables.
There are broadly two categories of stress tests used in banks viz. sensitivity tests and scenario tests. These may be used either separately or in conjunction with each other. Banks in India are beginning to use statistical models to measure and manage risks.