We propose a simple, parsimonious, and easily implementable method for the stress testing of banks using a top-down approach that evaluates the impact of negative shocks to macroeconomic variables on banks' capitalization. Our method relies on a least absolute shrinkage and selection operator (LASSO) approach for identifying the macroeconomic drivers of banking variables combined with a principal component analysis. We show how it can be used to make forward-looking projections, conditional on exogenous paths of macroeconomic variables. We also use a LASSO approach to identify the balance sheet and income statement factors that are key in explaining bank heterogeneity in response to macroeconomic shocks.
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