The Federal Reserve Board on Tuesday finalized changes to its stress testing program for the nation’s largest and most complex banks. The intent is to make the resiliency assessments “more open, transparent, and effective.”
“The changes are intended to improve public understanding of the program while maintaining its ability to independently test large banks' resilience,” it said in a statement.
Supervisory stress testing allows the Fed to assess whether the largest and most complex financial firms would be sufficiently capitalized during stressful economic conditions to absorb losses, meet obligations to creditors and other counterparties, and continue lending to households and businesses.
Supervisory stress test models are used to produce estimates of post-stress capital ratios for covered companies. Among these tools, the Dodd-Frank Act Stress Test (DFAST) is a forward-looking, quantitative evaluation of how stressful economic and financial market conditions could affect a firm’s capital holdings. The Fed’s annual Comprehensive Capital Analysis and Review (CCAR) focuses on forward-looking capital planning and the use of stress testing to assess firms’ capital adequacy.
The first of this week’s announced changes, which will begin for the 2019 stress test cycle and expand in subsequent years, will provide “significantly more information” about the stress testing models used in the annual CCAR reviews.
That information will include:
- ranges of loss rates, estimated using the Fed’s models, for actual loans held by CCAR firms;
- portfolios of hypothetical loans with loss rates estimated by the Board’s models; and
- more detailed descriptions of the Board’s models, such as certain equations and key variables that influence the results of the models.
“Using this additional information, a firm would be better able to evaluate the risks in its own portfolio or compare the losses from its own models to losses from the Board’s models,” the Fed’s statement says. It will provide additional information on a number of models, including those used to project operational-risk losses and pre-provision net revenue. The model disclosure will be updated each year and published in the first quarter.
The framework for the design of the annual hypothetical economic scenarios was also modified to “provide more information on the hypothetical path of the unemployment rate” and introduce a quantitative guide for the hypothetical path of house prices, “both of which are key variables for the scenarios,” the Board says.
The Fed will further explore incorporating stresses to other funding sources into its stress testing program in the future.
In an effort to foster greater public conversation about the CCAR process, in July the Fed will sponsor a conference focused on the transparency and effectiveness of stress testing. The event will convene panel discussions, drawing on a mix of presenters with industry, academic, and regulatory backgrounds. Written papers will be compiled and published to spur further research. “We expect the insights from the conference to inform the evolution of our stress-testing framework, and we hope to continue the conversation well after the conference ends,” Vice Chairman for Supervision Randal Quarles says. Details for the forum have not yet been announced.
Quarles elaborated on the stress test changes during a Feb. 6 speech before the Council for Economic Education in New York. He described the effort as taking steps “to improve a cornerstone of our post-crisis rules.”
Ten years have passed since the Federal Reserve conducted its first supervisory stress tests. “Our challenge now is to preserve the strength of the test, while improving its efficiency, transparency, and integration into the post-crisis regulatory framework,” he said.
Quarles stressed that stress tests have not remained static. “Just in the past several days, the Board acted to suspend stress tests this year for lower-risk firms—generally, those with total assets between $100 billion and $250 billion,” he noted. “The extended cycle provides administrative burden relief for these institutions and recognizes the different risks that they typically pose, especially compared to the largest and most complex firms, whose failure poses the greatest risk to the real economy.”
Even with this change, he added, stress tests “remain a core part of our supervision of these firms.”
“The question of how best to consolidate the gains from the first 10 years of stress testing deserves the attention and effort of the country's best minds,” Quarles said. “We should welcome changes and novel ideas, even when they explore stress testing in a new and unfamiliar light.”
Dennis Kelleher, president and CEO of Better Markets—a non-profit, non-partisan organization that supports Wall Street reforms—had a negative reaction to the Fed’s changes, suggesting that “by giving Wall Street’s biggest banks more information about the tests under the guise of ‘transparency,’ it risks following the failed path of Europe and snatching defeat from the jaws of victory.”
“The Fed’s rigorous and independent stress tests have been one of the most important and successful post-crash tools used by U.S. regulators,” he said in a statement. “In sharp contrast, Europe has used weak, bank-friendly stress tests that all the banks pass but remain systemic threats and unable to support economic growth. While transparency is generally good, it will be incredibly counterproductive if it allows the banks to game the tests. The Fed must be vigilant to ensure that that this critical tool does not become ‘no stress’ stress tests.”
New test scenarios
Meanwhile, this week also saw the public release of the scenarios banks and supervisors will use for 2019 CCAR and DFAST stress test exercises.
The tests, as they traditionally do, will apply three hypothetical scenarios: baseline, adverse, and severely adverse. For the 2019 cycle, the severely adverse scenario features a severe global recession in which the U.S. unemployment rate rises by more than 6 percentage points to 10 percent. “The hypothetical scenario features the largest unemployment rate change to date,” Quarles said. “We are confident this scenario will effectively test the resiliency of the nation’s largest banks.” The scenario also includes elevated stress in corporate loan and commercial real estate markets.
The baseline scenario is in line with average projections from surveys of economic forecasters.
Each scenario includes 28 variables (including gross domestic product, the unemployment rate, stock market prices, and interest rates) covering domestic and international economic activity. Firms with large trading operations will be required to factor in a global market shock component as part of their scenarios and incorporate a counterparty default scenario.
Banks are required to submit their capital plans and the results of their own stress tests to the Federal Reserve by April 5, 2019. The Federal Reserve will announce the results of its supervisory stress tests by June 30, 2019. The fill instructions for this year's CCAR will be released at a later date.