Stress testing and the risk appetite framework in action

Both use a baseline scenario (expected path) and a severely adverse scenario (a deep recession). Banks project nine quarters forward.

The scenario variables

A scenario is just a set of macro paths. A CCAR-style severely adverse scenario has historically included variables like:

• US unemployment rising sharply (past scenarios have used peaks around 10%; this is an illustrative range, not a fixed number)
• Real GDP contracting
• House prices and commercial real estate prices falling
• Equity markets dropping around 50% or more
• A market shock component for the largest trading firms (the "global market shock")

The bank translates these macro paths into losses on every portfolio.

Watching the capital ratio collapse

Let us run a simplified version. CET1 ratio is:

CET1 ratio = CET1 capital / Risk-Weighted Assets (RWA)

Risk-weighted assets weight each exposure by riskiness. A government bond might carry a 0% weight; an unsecured corporate loan, 100%.

Take our bank:

• CET1 capital: $25 billion
• RWA: $200 billion
• Starting CET1 ratio: 25 / 200 = 12.5%

Now apply the severely adverse scenario over nine quarters:

1. Credit losses. Loan defaults spike. Say projected loan losses net of some reserves reduce capital by $7 billion.

2. Trading and counterparty losses. The market shock hits the trading book: $2 billion.

3. Pre-provision net revenue (PPNR). The bank still earns money (net interest income plus fees minus expenses), but stressed revenue is thin. Say PPNR adds back $4 billion over the period.

4. Dividends. Assume the bank pays $1 billion in dividends it cannot skip in the projection.

Stressed CET1 capital:

25, 7, 2 + 4, 1 = $19 billion

Meanwhile RWA often rises in a downturn as risk weights climb. Say RWA grows to $210 billion.

Stressed CET1 ratio = 19 / 210 = 9.05%

The bank fell from 12.5% to about 9%. The minimum CET1 requirement is 4.5%, but with buffers the effective bar is higher (often 7% or more once the capital conservation buffer and any SCB are stacked). The drawdown here is roughly 3.5 percentage points. That number becomes the raw material for the Stress Capital Buffer.

From drawdown to a real capital requirement

Under the US framework, the SCB is broadly the maximum decline in the CET1 ratio during the stress test, plus four quarters of planned dividends, with a floor of 2.5%. A bigger drawdown means a bigger required buffer, which means less capital free to lend or return to shareholders.

That is the lever. Stress testing is not an academic exercise. It sets how much capital a bank must hold.

The risk appetite framework: turning scenarios into limits

A stress test tells the board how bad things could get. The Risk Appetite Framework (RAF) decides how much of that badness the bank is willing to tolerate, in advance, and enforces it through hard limits.

The centerpiece is the Risk Appetite Statement (RAS): a board-approved document stating the level and types of risk the bank will accept to hit its strategy. The Financial Stability Board's principles shaped how banks structure these.

From board statement to trading desk

The RAS is deliberately high-level. The magic is the cascade down to concrete limits.

Top of the house (board RAS): "We will maintain a CET1 ratio of at least 11% under our internal severely adverse scenario."

Translation step: If the stress test shows a 3.5 point drawdown, then to end above 11% the bank must start above roughly 14.5%. That gap drives everything below.

Cascade to business limits:

• Credit risk. Cap single-name exposure at, say, 10% of Tier 1 capital (the regulatory large-exposure ceiling in the EU is 25% of Tier 1; internal limits are usually tighter). Set a maximum for commercial real estate concentration, because that portfolio bled in the scenario.
• Market risk. Set a Value at Risk (VaR) limit for the trading book. VaR estimates the loss not expected to be exceeded on a normal day at a given confidence. Example: a 1-day 99% VaR limit of $40 million.
• Liquidity risk. Require a Liquidity Coverage Ratio (LCR) above 110% internally, above the 100% regulatory minimum. LCR = high-quality liquid assets / net cash outflows over 30 stressed days.
• Interest rate risk. Limit the earnings hit from a 200 basis point rate move.

The feedback loop

Here is the mechanism managers care about. The trader has a VaR limit. The lending officer has a concentration cap. Each limit traces back, through the cascade, to a board sentence about surviving a recession. When a desk breaches VaR, it is not just a policy violation; it is chipping into the buffer the board promised regulators.

Breaches trigger escalation: to the business head, then the Chief Risk Officer, then the board risk committee. Persistent breaches force position reductions.

Where due diligence fits

If you are assessing a bank (as an investor, counterparty, or acquirer), stress testing and the RAF are prime diligence targets.

Check the results, not just the ratio. A 12% CET1 today means little if the stressed CET1 is barely above minimum. Read the drawdown. US firms disclose SCB values; a rising SCB signals the Fed sees more risk.

Check for consistency. Does the RAS match actual behavior? If the statement says "low appetite for commercial real estate" but CRE is 300% of capital, the framework is decorative.

Check limit utilization. Ask how often desks run near their limits and how many breaches occurred last year. Chronic breaches signal either a broken RAF or a mispriced business.

Check the qualitative side. The Fed can fail a bank on qualitative grounds (weak modeling, poor governance) even if the numbers pass. In Europe, the ECB's Supervisory Review and Evaluation Process (SREP) can impose extra capital (a "Pillar 2" add-on) based on judgment about a bank's risk management.

A quick reconciliation you can do

Given disclosed figures, sanity-check the arithmetic:

Starting CET1 ratio          12.5%
Minus stressed drawdown      -3.5 pts
= Stressed minimum          = 9.0%
Regulatory minimum + buffer   7.0%
= Headroom                  = 2.0 pts

Two points of headroom on $200 billion of RWA is about $4 billion of surplus capital. Thin headroom means the bank has little room to grow lending or absorb a surprise. Fat headroom may mean the bank is over-capitalized and under-earning. Either way, the number tells a story.

Key Takeaways

• Stress tests set real capital requirements. In the US, the maximum CET1 drawdown under the Fed scenario feeds the Stress Capital Buffer (floor 2.5%); in the EU, EBA results inform the ECB's Pillar 2 add-ons.
• CET1 ratio = CET1 capital / RWA. In a severe scenario, capital falls (credit and trading losses) while RWA often rises, so the ratio drops on both sides at once.
• The Risk Appetite Statement cascades into hard limits: single-name and concentration caps, VaR limits, LCR floors, rate-sensitivity limits. Every desk limit traces back to a board promise about surviving a recession.
• In due diligence, read the stressed ratio and the drawdown, not just today's headline ratio, and test whether actual portfolios match the stated appetite.
• Governance can fail you even when the math passes: both the Fed's qualitative review and the ECB's SREP can impose more capital based on judgment.