Which of the following best describes the purpose of stress testing in financial institutions?

Stress testing in financial institutions is primarily designed to assess how a financial institution would respond to unlikely but severe market scenarios. This practice simulates extreme conditions, such as a financial crisis or massive shifts in market variables, to evaluate the resilience and stability of the institution under stress.

The importance of this lies in its role in identifying vulnerabilities that may not be evident during regular operations or under normal market conditions. By analyzing potential responses to these extreme situations, financial institutions can develop contingency plans, improve risk management processes, and ensure they have adequate capital buffers in place to absorb potential losses.

The other options focus on different aspects of risk management. Identifying potential losses over extended periods pertains to long-term risk assessments but doesn't capture the essence of stress testing, which is about evaluating responses to extreme conditions. Understanding behavior during normal market conditions is essential for standard risk assessments but is not what stress testing is primarily designed to do. Supporting baseline budgeting and financial projection deals more with forecasting and resource allocation rather than with the assessment of risks under extreme scenarios. Thus, the choice that aligns most closely with the core purpose of stress testing is the one that emphasizes severe market scenarios.