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Working Paper
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 ...
Speech
Testimony on improving financial institution supervision: examining and addressing regulatory capture
Testimony before the Senate Committee on Banking, Housing, and Urban Affairs Financial Institutions and Consumer Protection Subcommittee.
Discussion Paper
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.
Report
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 ...
Working Paper
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 ...
Discussion Paper
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 ...
Working Paper
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 ...
Working Paper
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 ...
Speech
Monetary, fiscal, and financial stability policy tools: are we equipped for the next recession?: remarks at the 2018 Economics Department Grossman Lecture, Colby College, Waterville, Maine, April 18, 2018
The focus of the talk was on tools that are available to policymakers once a significant adverse financial shock occurs.
Report
Supervisory stress tests
This article describes the background, design choices and particular details of stress tests used as part of an overall supervisory regime; that is, their formal integration into the process of the ongoing prudential supervision of banks and other large financial institutions. We then describe how the U.S. CCAR/DFAST regime is designed and what that means for the macroprudential vs. microprudential nature of the U.S. exercises. We argue routine stress tests have the potential to substantially change the nature of the supervisory process. In addition, we argue that a great deal depends on the ...