Regulators devise hypothetical future adverse economic scenarios to test banks known as stress tests. These established scenarios are then given to the banks in their jurisdiction and tests are run, under the close supervision of the regulator. They evaluate if the bank could endure the given adverse economic scenario, survive in business, and most importantly, continue to actively lend to households and business. If it is calculated that the bank can absorb the loss, and still meet the minimum bank capital requirements to remain in active business, they are deemed to have passed.
Example
For example, in the U.S. in 2012, an adverse scenario used in stress testing was all of the following:
*** A private conference call was held with banks to notify them of a new, two part information release by the Fed
****March 7, 2013 – Banks will be privately notified of the Fed's tentative decision on capital distribution plans.
**** Banks receiving a "no" will then have a 48 hours to privately resubmit to the Fed a reduced a distribution plan.
****March 14, 2013 – the Fed will publicly disclose final decisions on requests for capital distributions
****The week of private negotiations between the bank and the Fed will allow banks to adjust their request downward to what the Fed will allow. This was specifically designed to allow banks to avoid "embarrassing capital-plan rejections"
****Shareholder lawsuits are expected if banks fail to disclose capital distribution plans and Fed rejections as the majority of shareholders and prospective shareholders regard bank dividend and share buyback plans, and limits, to be extremely material information.
****Banks may not follow Fed advice and release capital distribution plans in advance of March 14.
