Stress Test Success and Bank Opacity
In contemplating the recent financial panic, it is easy to get lost in the weeds of repo markets and asset-backed securities and lose sight of the fact that, at the fundamental level, the panic was about inadequate information. Investors were uncertain about what particular assets were worth, and they were uncertain about which banks were exposed to those assets and to what degree. They were also uncertain about how the government would handle undercapitalized banks. It was against this background that the Treasury announced in February 2009 that the nineteen largest U.S. bank holding ...
CCAR: More than a Stress Test
The Federal Reserve recently released the results of its latest stress test of large bank holding companies (BHCs). While the stress test results have received a lot of attention, they are just one part of a much larger effort by the Federal Reserve to ensure that these large BHCs have robust processes for determining how much capital they need to maintain access to funding and continue to serve as credit intermediaries, even under stressed conditions. In this post, I describe these larger efforts and the role that the stress test plays in them.
The Failure of supervisory stress testing: Fannie Mae, Freddie Mac, and OFHEO
In the aftermath of the global financial crisis, policymakers in the United States and elsewhere have adopted stress testing as a central tool for supervising large, complex, financial institutions and promoting financial stability. Although supervisory stress testing may confer substantial benefits, such tests are vulnerable to model risk. This paper studies the risk-based capital stress test conducted by the Office of Federal Housing Enterprise Oversight (OFHEO) for Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that are central to the U.S. housing finance ...
The failure of supervisory stress testing: Fannie Mae, Freddie Mac, and OFHEO
Stress testing has recently become a critical risk management and capital planning tool for large financial institutions and their supervisors around the world. However, the one prior U.S. experience tying stress test results to capital requirements was a spectacular failure: the Office of Federal Housing Enterprise Oversight's (OFHEO) risk-based capital stress test for Fannie Mae and Freddie Mac. We study a key component of OFHEO's model?30-year fixed-rate mortgage performance?and find two key problems. First, OFHEO had left the model specification and associated parameters static for the ...
Measuring capital adequacy supervisory stress tests in a Basel world
The United States is now committed to using two relatively sophisticated approaches to measuring capital adequacy: Basel III and stress tests. This paper shows how stress testing could mitigate weaknesses in the way Basel III measures credit and interest rate risk, the way it measures bank capital, and the way it creates countercyclical capital buffers. However, this paper also emphasizes the extent to which stress tests add value will depend upon the exercise of supervisor discretion in the design of stress scenarios. Whether supervisors will use this discretion more effectively than they ...
Can We Take the “Stress” Out of Stress Testing? Applications of Generalized Structural Equation Modeling to Consumer Finance
Financial firms, and banks in particular, rely heavily on complex suites of interrelated statistical models in their risk management and business reporting infrastructures. Statistical model infrastructures are often developed using a piecemeal approach to model building, in which different components are developed and validated separately. This type of modeling framework has significant limitations at each stage of the model management life cycle, from development and documentation to validation, production, and redevelopment. We propose an empirical framework, spurred by recent developments ...
Stress Tests and Small Business Lending
Post-crisis stress tests have altered banks? credit supply to small business. Banks affected by stress tests reduce credit supply and raise interest rates on small business loans. Banks price the implied increase in capital requirements from stress tests where they have local knowledge, and exit markets where they do not, as quantities fall most in markets where stress-tested banks do not own branches near borrowers, and prices rise mainly where they do. These reductions in supply are concentrated among risky borrowers. Stress tests do not, however, reduce aggregate credit. Small banks ...
Evaluating the information in the Federal Reserve stress tests
We present evidence that the Federal Reserve stress tests produce information about both the stress-tested bank holding companies and the overall state of the banking industry. Our evidence goes beyond a standard event study, which cannot differentiate between small abnormal returns and large, but opposite?signed, abnormal stock returns. We find that stress test disclosures are associated with significantly higher absolute abnormal returns, as well as higher abnormal trading volume. More levered and riskier holding companies seem to be more affected by the stress test information. We find no ...
The macroprudential implications of the 1990s Japanese financial crisis: remarks at the 5th Annual Macroprudential Conference, Eltville, Germany, June 21, 2019
The Japanese financial crisis of the late 1990s had significant implications for both the Japanese and global economies. Effective use of macroprudential tools ? that is, banking regulations aimed at mitigating financial-system risk ? could have lessened the crisis in Japan. Unfortunately, it wasn't until the financial crisis of 2008 that countries began to work on improving macroprudential policies. Bank stress tests and the use of a countercyclical capital buffer (or CCyB) are two macroprudential tools that emerged from the financial crisis which could have reduced the severity of the ...
The adoption of stress testing: why the Basel capital measures were not enough
The Basel capital adequacy ratios lost credibility with financial markets during the crisis. This paper argues that failure was the result of the reliance of the Basel standards on overstated asset values in reported equity capital. The United States? stress tests were able to assist in restoring credibility, in part because they could capture deterioration in asset values. However, whether stress tests will prove equally valuable in the next crisis is not clear. Some of the weaknesses in the Basel ratios are being addressed. Moreover, the U.S. tests? success was the result of a combination ...