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A bank stress test, or banking stress test, is a simulation designed to assess a bank’s ability to withstand a severe economic or financial shock. In particular, it can be used to observe the consequences of an adverse scenario on the bank’s losses, earnings and capital.
Stress tests are therefore a tool for risk management and prudential supervision. According to the European Central Bank (ECB), they enable supervisors, among other things, to identify institutions’ vulnerabilities and address them through the supervisory dialogue.
The adverse scenario is hypothetical and does not constitute a forecast of future economic or financial-market developments. It is compared with a baseline scenario generally based on central macroeconomic projections.
What is a bank stress test and what is it used for?
Definition of a bank stress test
A stress test theoretically subjects a bank to a particularly adverse economic or financial situation in order to estimate how its balance sheet, earnings and capital might develop if the simulated risks were to materialise.
In particular, it can be used to assess an institution’s ability to absorb significant losses while continuing to comply with the prudential requirements to which it is subject.
A stress test should therefore be distinguished from a forecast. The selected scenario may deliberately be much more severe than central economic expectations in order to assess the bank’s resilience under extreme but plausible conditions.
Why do authorities conduct banking stress tests?
The tests serve two purposes. From a microprudential perspective, they help identify vulnerabilities specific to an institution and assess its solvency under different shocks.
From a macroprudential perspective, analysing several banks can identify weaknesses that could affect the banking system and financial stability more broadly. The ECB therefore distinguishes tests conducted for the individual supervision of institutions from macroprudential exercises focused on system-wide consequences.
How does a bank stress test work?
Step 1: build a baseline scenario and an adverse scenario
Major European stress tests generally use two economic paths.
Baseline scenario | Adverse scenario |
Central economic path | Deliberately adverse assumptions |
Provides a point of comparison | Tests banks’ resilience |
Baseline economic conditions | Recession, defaults, property shock, markets, interest rates… |
The adverse scenario may therefore combine a severe recession, rising unemployment, falling property prices, a sharp decline in certain financial markets, an increase in defaults or significant movements in interest rates.
For the 2025 European exercise, the macro-financial scenario published by the European Systemic Risk Board (ESRB) covered, among other things, real GDP, inflation, unemployment, property prices, equity markets, interest rates and exchange rates. The document expressly states that the adverse scenario is hypothetical and does not constitute a forecast.
Step 2: measure the impact of the shock on the bank
The assumptions are then applied to the bank’s activities in order to project their impact on its balance sheet and income statement.
The mechanism can be summarised as follows:
Economic shock → increase in defaults and losses → fall in earnings → possible erosion of capital → deterioration in prudential ratios.
An increase in borrower defaults may, for example, result in higher provisions and credit losses. Market movements may at the same time cause asset write-downs.
In the EU-wide exercise, banks carry out a significant proportion of their projections using a bottom-up approach, based on their own data and models and in accordance with the common methodology defined by the European Banking Authority.
Step 3: review and validate the results
The submitted results are subject to a control and quality-assurance process. The competent authorities review, among other things, the data used, the consistency of the projections and compliance with the methodology.
They may critically review certain estimates and request adjustments where projections do not comply with the constraints defined for the exercise.
What risks can a bank stress test assess?
Credit risk and borrower defaults
Credit risk includes the risk that an individual or company may no longer be able to repay its debt.
A deterioration in economic conditions may increase the number of defaults, require banks to recognise higher provisions and generate losses on their loan portfolios.
Market risk, interest-rate risk and counterparty risk
Counterparty risk is the risk that a party with which a bank has entered into a financial transaction may be unable to meet its obligations.
Stress tests may also incorporate falls in the value of certain securities, movements in interest rates or difficulties experienced by financial counterparties.
The objective is to assess the consequences of these events for the bank’s different activities and, ultimately, for its capital.
Operational, geopolitical and emerging scenarios
Thematic exercises may complement the major macroeconomic scenarios. Supervisors may, for example, examine operational risk, cyber risk, climate-related risks or the consequences of geopolitical tensions.
In years without an EBA EU-wide stress test, the ECB therefore conducts thematic exercises covering risks considered to be supervisory priorities.
Bank stress tests and the CET1 ratio: how is solvency measured?
What is the CET1 ratio?
The CET1 (Common Equity Tier 1) ratio compares a bank’s highest-quality regulatory capital with its risk-weighted assets.
In simplified terms:
CET1 ratio = CET1 capital / risk-weighted assets.
It is one of the main indicators used to assess a bank’s ability to absorb losses.
How does an adverse scenario affect capital?
As losses increase, they weigh on the institution’s earnings and may progressively reduce its capital. This erosion may lead to a decline in the CET1 ratio.
The term “capital depletion” is used, among other things, to describe the reduction in capital or in the capital ratio over the course of the stress scenario.
Recession → defaults → losses → reduction in capital → possible decline in CET1.
The analysis is not limited to CET1. Supervisors also examine other prudential indicators, including the leverage ratio and compliance with applicable capital requirements and buffers.
Who organises bank stress tests in Europe?
The role of the EBA, ECB and ESRB
Several institutions are involved in European exercises.
The European Banking Authority (EBA) coordinates the EU-wide stress test and establishes a common methodology. This responsibility is based in particular on Article 32 of Regulation (EU) No 1093/2010 establishing the EBA, which provides for the EBA to initiate and coordinate Union-wide assessments of the resilience of financial institutions to adverse market developments.
The European Systemic Risk Board (ESRB) contributes to the design of the adverse macro-financial scenario. The ECB is responsible for institutions within the Single Supervisory Mechanism (SSM), while national competent authorities, including the ACPR in France, also participate in supervision.
The ECB’s prudential role derives in particular from Regulation (EU) No 1024/2013 on the Single Supervisory Mechanism, which confers specific banking-supervision tasks on the ECB.
Bank stress tests, the SREP and capital requirements
A European stress test should not be interpreted as a simple examination with a “pass” or “fail” result. The EBA also states that its EU-wide exercise does not use a predefined pass/fail threshold.
The results feed into the SREP (Supervisory Review and Evaluation Process), during which the supervisor assesses each institution’s risk profile.
The quantitative stress-test results are also an important input into the setting of Pillar 2 Guidance (P2G). The ECB explains how this Pillar 2 guidance works and, in particular, that it takes account of the depletion in the capital ratio observed under the stress scenario.
What regulatory framework governs bank stress tests?
Stress tests form part of the European prudential framework for banks.
Directive 2013/36/EU on capital requirements (CRD) is one of the central legislative texts. Article 100 provides that competent authorities should, where appropriate and at least annually, carry out supervisory stress tests on the institutions they supervise in order to facilitate the supervisory review and evaluation process.
Regulation (EU) No 575/2013, or the CRR, governs a large part of the prudential requirements applicable to credit institutions, including requirements relating to capital and risk-weighted assets.
This framework has evolved, in particular, through Directive (EU) 2024/1619, known as CRD VI, and Regulation (EU) 2024/1623, known as CRR III, which contribute to implementing the latest reforms of the international prudential framework in the European Union.
What do the results of a bank stress test show?
How should a decline in CET1 be interpreted?
The result should not be analysed solely on the basis of the final CET1 level. The starting level, the losses generated by the scenario, the scale of the decline in the ratio and the capital remaining at the end of the simulation should also be considered.
The results should also be considered in the context of the prudential requirements applicable to each institution.
Example: the 2025 European stress tests
According to the results of the 2025 stress test published by the EBA, the EU-wide exercise covered 64 banks in 17 European Union and European Economic Area countries, representing approximately 75% of the assets of the European banking sector.
For the French institutions covered by the EBA and ECB exercises, the ACPR states in its publication on the 2025 results that, under the assumptions of the adverse scenario and taking account of transitional measures, the aggregate CET1 ratio would fall from 15.91% to 10.52%.
These figures are the results of a hypothetical scenario defined for the exercise. They do not constitute a forecast of how the ratios of the institutions concerned will develop in the future.
What are the implications of a bank stress test for a bank and its investors?
What can happen when a bank appears vulnerable?
The results may lead the supervisor and the institution to consider various measures, such as strengthening capital, reducing certain exposures, changing the balance-sheet structure or modifying the distribution policy.
The response nevertheless depends on the bank’s individual circumstances, risk profile and the overall prudential assessment. A stress test therefore does not automatically determine any particular measure.
What does it mean for subordinated bonds?
The results may also provide information relevant to analysing an issuer of subordinated bank bonds, since these instruments rank below certain senior debt for repayment and may, depending on their characteristics and the applicable framework, participate in loss absorption.
However, a stress test alone is not sufficient to assess their level of risk. Factors to consider include the issuer’s credit quality, the level of subordination, contractual terms, loss-absorption and resolution mechanisms, and the other risks specific to the security concerned.
What it does (and does not) say about subordinated bank bond funds
When analysing subordinated bank bond funds, stress tests can provide information on the prudential position and theoretical resilience of certain issuers held in the portfolio.
However, they are neither a sufficient indicator of a fund’s level of risk nor an indicator of its future performance. Analysis of a fund should take account, among other things, of its investment policy, portfolio composition and the various risks to which it is exposed.
For illustrative purposes, Axiom Financial Credit is a subordinated bank bond fund with exposure, among other things, to subordinated bonds issued by the financial sector. The stress-test results presented in this article do not indicate the fund’s future performance or its level of risk.
For information on its characteristics, risks and charges, please consult its dedicated page, Key Information Document and prospectus before making any investment decision.
What are the limitations of a bank stress test?
A stress test is based on assumptions
The results necessarily depend on the selected scenario, the available data, the models used and the methodological constraints defined by supervisors.
A different scenario could therefore produce different results. Some risks may also be difficult to model or may materialise through mechanisms that were not envisaged in the exercise.
A bank stress test is neither a forecast nor a guarantee
A stress test cannot predict the next financial crisis. Similarly, favourable results do not mean that a banking institution is free of risk or that it will necessarily withstand every future event.
Stress tests should therefore be regarded as one prudential-analysis tool among others, whose results are meaningful when considered as part of a broader analysis of the bank, its environment and the risks to which it is exposed.