“What Would Happen If…?” Why Stress Testing is Important

Every year, the Central Bank of Barbados and the Financial Services Commission (FSC) publish the Financial Stability Report, which analyses the health of the financial system during the previous year. And while it is important to understand how sound the different players in the system are currently, it’s equally important to understand how they would perform if something unexpected should occur. That’s where stress testing comes in.

What is Stress Testing?

Anton Belgrave, Director of the Central Bank of Barbados’ Research and Economic Analysis Department (READ), explains that the goal is to identify potential weaknesses in the financial system. To do this, regulators conduct simulations that assess the different sectors; as well as individual entities’ ability to withstand extreme shocks. “The idea behind stress tests is you are looking for areas where you can force the system to fail. So, in a sense, they are a little unfair to the entities, because we essentially test to destruction.”

For stress testing to provide useful information, the scenarios regulators use should be “extreme but plausible,” says Belgrave, and the results of them become a starting point for discussion with the specific entities, should the findings be concerning. Regulators can also issue revised guidelines, but Belgrave says this tends to happen only as a last resort because the existing guidelines are already quite comprehensive.

What Do Recent Stress Tests Show?

For the 2020 Financial Stability Report, the Central Bank and the FSC focused heavily on credit risk – the risk that borrowers will not repay their loans. This was because the ongoing pandemic has led to a slowdown in the economy and an increase in unemployment, which could impact both businesses’ and households’ ability to repay their loans.

The stress tests conducted as part of the 2020 Financial Stability Report reveal that the overall financial system remains “fairly resilient” to credit shocks. Commercial banks, which control more than half of the financial system’s assets, have been very resilient and have been able to handle the fallout from the pandemic. This is largely due to their high liquidity (liquidity is the availability of cash or assets that can easily be converted to cash) and the fact that they are well-capitalised (capital acts as a buffer that allows financial institutions to withstand shocks). Credit unions and finance and trust companies, which control 11 percent and 4 percent of the system’s assets, respectively, remain fairly resilient.

Belgrave says that while he is pleased to see how commercial banks are able to withstand the challenges created by the pandemic, he would like to see other deposit-taking financial institutions increase their provisioning (the money they set aside to cover loans in case they go into default). He sees this as the area of greatest concern for him as a regulator.

Why Does All of this Matter to the Average Barbadian?

Talk of stress testing, provisioning, capital, and liquidity might lead the average Barbadian to view what happens in the financial system as removed from their daily lives, but Belgrave says that is decidedly not the case:

“Everybody, or just about everybody who is working in the formal or even informal financial system interacts with it in some way. We have our savings in the banks, we have insurance policies, we have some relationship with our credit union… These things are very central to modern life. I doubt we would have reached the standard we have reached without the growth of the financial system. The collapse of any financial entity, or the whole financial sector is quite devastating to an economy… It basically represents the destruction of wealth. So, this is why you should pay attention, because ultimately, if our financial system collapses, it will affect you.”

And that’s precisely why the Central Bank and the FSC pay such close attention. As Barbados’ financial regulators, they monitor the different players in the local financial system and conduct stress testing to ensure that the system remains stable and the assets of Barbadians are secure.