Better Ways to Test Banks’ Stress

Regulators around the world have used a three-pronged strategy to assure that no bank ever again becomes so large it poses systemic risk to the financial world: steeper fines, higher capital reserves, and stress tests.

It’s that last one that really seems to be, well, stressful.

“Stress tests have never worked,” says William Black, professor of economics and law at the University of Missouri-Kansas City. “They typically don’t look at the things that will really kill you. It’s like going in for a medical exam and the doctors don’t look at your heart, they just ask about your diet.”

The tests, administered by banking regulators such as the Federal Reserve, present a variety of macro-economic scenarios that range from slight market disruptions to total chaos; they are intended to gauge whether banks can manage their way through such turmoil without triggering another financial crisis akin to 2008.

Critics say the tests are flawed, an academic exercise at best. And with the Fed recently releasing the criteria it will use for stress tests in 2015, plus results from the European Union’s tests released just weeks ago, those skeptics are again faulting the stress tests and offering ideas for how to incorporate smarter tests into a larger risk-management context.

Arguments can be made that systemically important financial institutions should have high capital requirements: The largest banks would not grow as much, the thinking goes, which means they would not have as much leverage, and the scale of the next crisis would be reduced. So, therefore, give big banks a stress test every year and, if they fail, ratchet up their required capital reserves.

“Stress tests have never worked. They typically don’t look at the things that will really kill you. It’s like going in for a medical exam and the doctors don’t look at your heart, they just ask about your diet.”
William Black, Economics, Law Professor, University of Missouri-Kansas City

The problem? “Capital itself will not prevent a crisis,” Black says. Keeping up the quality of assets on the balance sheet prevents a crisis—and right now, he says, stress tests in the United States and Europe don’t much consider that.

James Kaplan, a partner at law firm Quarles & Brady who previously worked as in-house counsel at multiple banks, agrees. “While the better-capitalized institutions did well during the last cataclysm, one of the things we saw was that capital wasn’t the silver bullet,” he says. “If your assets were bad, almost no amount of reasonable capital that anybody had was enough to withstand it.”

One area where the tests are “wildly successful,” Black surmises, is as a public relations exercise. In his view, they are more about publicizing that banks are stronger and safer after the financial crisis, and even those that fall short can fix their failings with relative ease.

Similar complaints dogged stress test results in Europe. The European Central Bank tested 130 banks; 25 failed, but 12 have already fixed the capital-adequacy problems they were cited for. Given the challenging climate for European banks, the relatively low number of at-risk institutions has experts questioning whether the tests were stringent enough.

“A number of things are wrong with the ECB’s stress test,” says Daniel Satchkov, president of RiXtrema, a portfolio stress-testing software company. “The shocks do not appear strong enough.” The chosen scenarios, for example, ignored the threat of deflation. “The regulators realized that if they tried realistic adverse scenarios, more institutions would fail and could cause a bank run,” he says.

The Federal Reserve recently released its own stress scenarios for 2015 as part of the Comprehensive Capital Analysis and Review required by the Dodd-Frank Act for bank holding companies with $50 billion or more of total consolidated assets. The scenarios are both more stringent than the ECB’s criteria and an improvement over past tests, Satchkov says. For example, they are far more demanding for equity market shocks, with severe models based on a drop of 58 percent in U.S. equities through the end of 2015—as bad as the worst of 2008-09.

That said, the Fed went easy on other segments of the marketplace, such as high-yield corporate debt, “so the tests would instill confidence, not stoke fears,” Satchkov says. “The Fed assumed the credit market will hold up much better than the equity market, which may or may not happen.”

Is There a Fix?

Critics of stress tests don’t advocate for abolishing them, but rather that they be improved and positioned as part of a larger risk-management strategy. Regulators should move away from asset size to determine whether a bank is “too big to fail” and look to other factors that also affect a bank’s influence, from the number of clients it serves to the diversity of its businesses, and its status as a multi-national or national company, says Susan Palm, vice president of industry solutions at MetricStream, a GRC software vendor.

Company earnings and institutional liquidity should also be tested, Brenda Boultwood, head of industry solutions at MetricStream, says. “There is too much emphasis on capital, and not enough on what could wipe out the earnings of a company,” she says.

Satchkov says regulators should reconsider the timing of disclosing results to the public, because a quick release puts pressure on regulators to avoid bad news that could cause a bank run. A three-month delay in posting results, he suggests, would allow regulators to consider tougher scenarios.

STRESS TEST PLOTLINES

In October, the Federal Reserve Board issued the supervisory scenarios that were be used in the 2015 capital planning and stress testing program. See the scenarios below.

The baseline scenario calls for a sustained, moderate expansion in economic activity. Real GDP grows at an average rate of just under 3 percent per year; the unemployment rate declines modestly, reaching 5.25 percent by the fourth quarter of 2017; and CPI inflation averages just over 2 percent per year.
Short-term Treasury rates increase to just over 3 percent by the end of 2017. Spreads on investment-grade corporate bonds change little, as do spreads on residential mortgages and other consumer loans. Equity prices, nominal house prices, and commercial property prices all rise steadily. Equity market volatility remains at low levels.
Adverse Scenario
The adverse scenario is characterized by a global weakening in economic activity, an increase in U.S. inflationary pressures, and a rapid increase in both short- and long-term U.S. Treasury rates.
The U.S. experiences a mild recession and the unemployment rate increases to just over 7 percent. There is a considerable rise in core inflation and short-term interest rates rise quickly, reaching 5.25 percent by the end of 2017.
Equity prices fall to 25 percent lower than in the third quarter of 2014. House prices and commercial real estate prices decline by approximately 13 and 16 percent, respectively.
Severely Adverse Scenario
The U.S. corporate sector experiences increases in financial distress that are even larger than would be expected in a severe recession. There is a widening in corporate bond spreads, and a decline in equity prices. The scenario also includes a rise in oil prices (Brent crude) to approximately $110 per barrel.
In the “deep and prolonged recession” the unemployment rate peaks at 10 percent by the middle of 2016. Despite lower long-term Treasury yields, corporate financial conditions tighten significantly.
Equity prices fall by approximately 60 percent from the third quarter of 2014 through the fourth quarter of 2015, and equity market volatility increases sharply. House prices decline by approximately 25 percent during the scenario period relative to their level in the third quarter of 2014, while commercial real estate prices are more than 30 percent lower at their trough. There are also severe recessions in Europe and Japan, exacerbated by the rise in oil prices.
Source: Federal Reserve.

Ultimately, the regulatory focus—within and beyond stress tests—must to be on risk management, not just capital requirements, Kaplan says. “Capital won’t save you if your risk management is bad,” he says. “It is like closing the barn door after the horse is gone. The current stress tests are saying that if your portfolio is dangerous you need more capital. But you should try to change the danger in your portfolio. Stress tests may be one piece of a whole risk-management strategy, but over-reliance on them is wrong.”

Anna Krayn, director and enterprise risk solutions specialist for Moody’s Analytics, concedes that thinking about your risk-management infrastructure can be tricky, since managers do have an immediate need to focus on shareholder returns and quarterly performance. Still, boards should be prompted to focus more on risk management when they give their blessings to a stress testing submission.

Research by Moody’s suggests that this is happening. More than 80 percent of respondents to a recent survey reported that compliance with regulations would drive resource allocation over the next two to three years, with a particular focus on meeting stress testing requirements in the United States and Europe. Respondents said they expect to leverage their investments in stress testing to better assess capital adequacy and undertake capital planning, upgrade their general risk-management and measurement efforts, improve risk appetite definition, and conduct strategic planning.

The CCAR budget at many institutions is in the tens of millions of dollars and “is too much money to be a mere compliance exercise,” Krayn says. “Throwing people at the problem, which was the original way banks responded, is not sustainable.” Banks are increasingly looking to technology not only to streamline the stress testing process, but to better leverage the data that stress tests create, bringing “real-time, real-life capital perspectives that empower better management decisions.”

Over time, regulators and banks alike will delve more into specific risks, Boultwood says. “Every bank has a slightly different model and operates in different geographic markets and with different products, so you want to know what a bank identifies as the specific risks it is influenced most by, as opposed to just general systemic risk factors,” she says. “Calling out specific risk factors in the CCAR stress testing guidelines would shift the discussion from regulators developing systemic risk factors to institutions thinking deeply about their business model and what could disrupt liquidity, earnings, or capitalization.”

As banks get a better handle on risk analysis and data, stress tests, whether internal or developed by regulators, could also get more complex. “Instead of a handful of scenarios, we might see 25 or 50 scenarios run monthly, maybe even weekly,” Krayn says. “Everything can be standardized so that when management wants to run a risk analysis it doesn’t take six to eight weeks to produce the result, which is what we have right now.”