What best describes "stress testing" in banking?

Stress testing in banking is best described as a simulation used to assess how banks can handle economic shocks. This process involves creating hypothetical scenarios that can negatively impact the financial health of a bank, such as a severe economic recession, a significant increase in unemployment rates, or a sharp decline in asset values. The goal is to evaluate the bank's resilience and stability under adverse conditions, ensuring that it can maintain adequate capital levels and continue to operate without requiring government intervention or assistance.

Through stress testing, banks can identify vulnerabilities within their systems, allowing them to develop strategies for risk management and improve their overall financial health. This practice is an essential component of regulatory requirements and is aimed at promoting the stability of the financial system as a whole.