The U.S. Federal Reserve recently released the results of a comprehensive assessment of the financial conditions of the nation’s 19 largest banks, which hold two-thirds of American economic assets. This “stress test” was designed to determine the capital buffers required for the banks to withstand losses and maintain lending even in worsening economic conditions. Officially called the Supervisory Capital Assessment Program (SCAP), the test identified the potential losses, resources available to absorb losses, and resulting capital buffer needed.
Monte Carlo simulation was used to determine the potential losses from further defaults on loans. According to Federal Reserve Chairman Ben Bernanke, “The assessment program was a forward-looking, ‘what-if’ exercise.”
Monte Carlo simulation is one of the most widely used methods of stress testing for capital and operations risk, according to Investopedia. It takes into account variables such as interest rates, lending requirements, and unemployment. As any @RISK software user will tell you, this type of sophisticated simulation can be accomplished easily within the Microsoft Excel environment. The result of a Monte Carlo software simulation is a look at a whole range of possible outcomes, including the probabilities they will occur — a valuable tool when stress testing.