Stress Testing
Design scenarios that are severe enough to teach and plausible enough to act on.
Stress testing asks what happens when history stops being a guide. Scenarios come in three flavors: historical replays of episodes like 1987 or 2008; hypothetical narratives built from named macro shocks; and reverse stress tests, which start from a chosen failure and search for scenarios that would produce it. The craft is balancing plausibility against severity: a scenario management dismisses teaches nothing. Regulators turned the exercise into a capital constraint through annual programs such as the Federal Reserve’s stress tests, and internal capital plans lean on the same machinery. Unlike value-at-risk calibrations, which live inside normal regimes, stress tests assume the regime breaks; backtesting audits the results.