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 ...
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.
Stress Tests and Information Disclosure
We study an optimal disclosure policy of a regulator that has information about banks (e.g., from conducting stress tests). In our model, disclosure can destroy risk-sharing opportunities for banks (the Hirshleifer effect). Yet, in some cases, some level of disclosure is necessary for risk sharing to occur. We provide conditions under which optimal disclosure takes a simple form (e.g., full disclosure, no disclosure, or a cutoff rule). We also show that, in some cases, optimal disclosure takes a more complicated form (e.g., multiple cutoffs or nonmonotone rules), which we characterize. We ...
The new era of supervision: progress to date and the road ahead
Remarks at the New York Bankers Association's Annual Meeting, New York City.
The past and future of supervisory stress testing design: remarks at the 2018 Federal Reserve Stress Testing Research Conference, Federal Reserve Bank of Boston
Remarks at the 2018 Federal Reserve Stress Testing Research Conference, Federal Reserve Bank of Boston, Boston.
Stress testing effects on portfolio similarities among large US Banks
We use an expansive regulatory loan-level dataset to analyze how the portfolios of the largest US banks have evolved since 2011. In particular, we analyze how the commercial and industrial and commercial real estate loan portfolios have changed in response to stress-testing requirements stipulated in the 2010 Dodd-Frank Act. We find that the largest US banks, which are subject to stress testing, have become more similar since the current form of the stress testing was implemented in 2011. We also find that banks with poor stress test results tend to adjust their portfolios in a way that makes ...
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 ...
Debt-Overhang Banking Crises
This paper studies how a worsening of the debt overhang distortion on bank lending can explain banking solvency crises that are accompanied by a plunge of bank asset values and by a severe contraction of lending and economic activity. Since the value of bank assets depends on economic prospects, a pessimistic view of the economy can be self-fulfilling and can trigger a financial crisis: If economic prospects are poor, bank asset values decline, the bank risk of default rises, and the associated debt overhang distortion worsens. The worsening of the distortion leads to a contraction in bank ...
MODEL SECRECY AND STRESS TESTS
Conventional wisdom holds that the models used to stress test banks should be kept secret to prevent gaming. We show instead that secrecy can be suboptimal, because although it deters gaming, it may also deter socially desirable investment. When the regulator can choose the minimum standard for passing the test, we show that secrecy is suboptimal if the regulator is sufficiently uncertain regarding bank characteristics. When failing the bank is socially costly, then under some conditions, secrecy is suboptimal when the bank's private cost of failure is either sufficiently high or sufficiently ...
Resilience of Community Banks in the Time of COVID-19
Stress tests in December 2020 showed that the largest U.S. banks had strong capital levels and could continue to lend to households and businesses under hypothetical severe recessions. Assessing thousands of small community banks against similar criteria suggests that, while about one-fifth could fall below adequate capitalization, only a handful of those risk becoming insolvent. Overall, this is a reassuring view for small banks and their communities, suggesting that the risk of widespread bank failures leading to financial instability appears to be small.