Driving along a wooded section of Florida highway, I noticed a haze of smoke among the trees and wasn’t sure what I was witnessing. A specific area of the forest had been burned, with care to preserve the trees but to destroy the undergrowth. I turned to my outdoorsy father-in-law in the passenger seat and asked him about the purpose of the intentionally set fires. He explained: “They help prevent bigger fires.”
In Florida, as well as in other dry parts of the country, wildfires happen regularly and sometimes spread uncontrollably. The additional fuel of the undergrowth not only extends their range, but also increases the temperature at which they burn, making them far more deadly for responders. By stress testing various tracts of woodlands for the potential of a fire, private landowners or Forestry Services can determine which, if any, preemptive measures should be taken to reduce the risk and frequency of wildfires.
In the banking world, the Fed is seeking to employ a similar strategy in order to prevent a recurrence of the 2008 “wildfire”. By observing historical data in order to measure relevant variables like the Probability of Default of a given financial institution, the Fed can perform stress tests in order to determine where and when to take minor actions (setting brush fires) so as to avoid major catastrophes. While those minor actions tend to be regulatory, and thus highly politicized and hotly debated, the model of stress testing is a practical one for application in our personal financial lives.