After the majority of European banks passed their landmark stress tests, equity markets climbed, credit default swap spreads tightened, high-risk sovereign debt rallied and the euro extended its gains against the dollar.

A similarly positive response followed the US bank stress tests in 2009. Yet it is important for market participants to realise that this risk-management strategy - much enhanced by recent technological advances - is not a one-off procedure, only to be used in an emergency. Had stress testing - a procedure that provides a picture of risk under unknowable future situations - enjoyed the same attention prior to the summer of 2008, the extent of the ensuing crisis might have been markedly different.

Frequent evaluation

Indeed, risk-management best practice requires frequent stress testing of assets in order to regularly evaluate perceived stresses on a scale from 'most probable' to 'least probable'. Once these baseline risks are plotted, they can then be tracked over time to determine whether or not they are gaining in likelihood.

The next step is mapping current scenarios to actual historical events - and the impacts those events had on valuations and fundamentals at the time. This is much more than a one-to-one comparison - historical analysis requires a deep understanding of the often unpredictable correlations between the universe of assets being stressed, both on a historical and present-day basis. These relationships have to be measured, updated and stored every day.

Not long ago, this level of analysis was extremely difficult. In fact, when stress testing was first introduced in the early 1990s, it was essentially a worst-case scenario tool developed to augment JPMorgan's value-at-risk methodology - preparing risk managers for those rare 'fat tail' or 'black swan' occurrences that can send shockwaves through a portfolio. But it was a very computer processing-intensive process, heavy on complex mathematical calculations to identify the correlations and probabilities of shock events.

Computer firepower

Today, theories can be applied more widely in fractions of a second thanks to the exponentially increased firepower built into current technology resources. In large part due to technological developments, investors can now track the relationship between individual balance-sheet items and overall company-wide financials, and then test those relationships against a multitude of different stress scenarios - without an army of PhDs poring over spreadsheets.

Indeed, leading firms have been investing heavily in powerful new grid computing technology that delivers the capacity to perform this depth of analysis.

The grid architecture being engineered today not only speeds up the multitude of calculations being made during a stress-testing exercise but also allows the use of far larger pools of input data. This increases the precision and sophistication of the stress scenarios being tested. The calculations can be applied to every item on a company's balance sheet, to its profit and loss figures and to all its fundamental data.

Fundamental tool

The huge new correlation matrices being devised, combined with today's super-computer processing capabilities, will transform the practice of stress testing and help encourage its use as a fundamental risk-management tool.

But the big question now is whether market participants have taken the results of the US and European bank stress tests as a call to action.

To avoid falling into the same traps as in the last crisis, it is essential that stress testing becomes an ongoing, integral and aggressively pursued endeavour for policy-makers both public and private as a way to understand and estimate risk better. Indeed, stress testing must become part of our everyday decision-making process, informing not just risk managers but also asset managers and the C-suite.

Michael Thompson is managing director for valuation and risk strategies at Standard & Poor's

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