Supervisors run stress tests to find out whether a bank would still be solvent after a severe shock. The test is a modelling exercise rather than a forecast, and the distinction matters.
A scenario is imposed, not predicted
Supervisors publish a hypothetical path for unemployment, output, property prices, interest rates and market volatility over several years.
The path is deliberately severe, generally worse than recent experience, because the purpose is to test resilience rather than to estimate likely outcomes.
Banks then apply that scenario to their own portfolios and report what happens to losses, income and capital in each year of the path.
Capital is the measure that matters
The output is a capital ratio, comparing loss-absorbing equity with assets weighted by their risk.
A bank passes if that ratio stays above a stated minimum throughout the scenario, including at its worst point rather than only at the end.
Capital matters because it absorbs losses before depositors and bondholders are exposed, so the test asks how much a bank could lose while remaining viable.
The scenario design carries the assumptions
A test only finds the weaknesses the scenario reaches, so a severe housing shock reveals mortgage exposure and says little about a bank concentrated in trading.
Supervisors vary the emphasis between rounds and add exploratory scenarios covering areas the standard path misses.
Critics note that a known scenario invites optimisation, since a bank can position itself to score well on the published test rather than to be broadly resilient.
Results change what banks may do
Where a bank falls short, supervisors can restrict dividends and share buybacks until capital is rebuilt.
Because those restrictions affect returns to shareholders directly, the test influences bank behaviour continuously rather than only when results are published.
Some regimes also set a bank's required capital partly from its stress result, which makes the exercise a live constraint rather than a periodic examination.
What the exercise cannot capture
Tests are run bank by bank, so they struggle with contagion, where one firm's distress becomes another firm's loss.
They also assume balance sheets behave in modelled ways, whereas a real crisis involves funding drying up and asset sales that move prices further.
Nor do they capture behaviour, since a bank under strain lends less, which weakens the economy further and produces losses the scenario never specified.
Supervisors treat results as one input among several rather than as a verdict, and the published detail is intended to let markets form their own view rather than to certify safety.