Capital and liquidity standards for banks and other financial institutions proved to be inadequate during the financial meltdown of 2008. The severity of the crisis, coupled with deficient data quality, models, risk-management practices and regulatory oversight, rendered those standards meaningless. To prevent this from happening again, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was passed and, among other mandates, it requires stress tests for individual institutions and the financial system as a whole.
A stress test determines whether an institution—or the broader financial system—would have sufficient capital and liquidity to survive a steadily deteriorating economy or a sudden economic shock. If either capital or liquidity drops below acceptable minimums during the test, it is a signal that the business models or risk-management practices should be changed.
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