These tests, based on historical or hypothetical stress scenarios, lend greater plausibility to the stress testing exercise and also yield a more accurate assessment of total losses under adverse developments. Not surprisingly, they are relatively more difficult to implement as it is difficult to anticipate the manner in which different macro variables would move together, especially under conditions of stress.
Of late, there is an evidence of the increased use of macroeconomic models to design stress tests. Economic models are being used to examine the linkages between the health of financial institutions and underlying driving factors (macro-financial variables or latent factors). Often, these models also incorporate the feedback effect from the banking system to the rest of the economy.