Federal Reserve Chairman Ben Bernanke, speaking at a Federal Reserve Bank of Atlanta sponsored conference on Monday said that the use by the Fed of supervisory stress tests has helped the banking system recover and along with it the overall economy. Methodologically, he said, stress tests are forward looking and focus on unlikely but plausible risks, as opposed to "normal" risks and thus complement more conventional capital and leverage ratios. They have evolved considerable since they were first conducted in 2009 in the wake of the near collapse of several major banks the previous year.
Bernanke said that, like all bureaucracies, the Federal Reserve "has an unfortunate tendency to create acronyms." Those relevant to his presentation are the basic test, the Supervisory Capital Assessment or SCAP. The tests required by the Dodd-Frank Act, called DFAST, quantitatively assess how bank capital levels would fare in stressful economic and financial scenarios. The Comprehensive Capital Analysis and Review, or CCAR, combines the quantitative results from the stress tests with more-qualitative assessments of the capital planning processes used by banks.
The first SCAP provided anxious investors with credible information about prospective losses at banks, helped restore confidence in the banking system and enabled its successful recapitalization. Today, Bernanke said, the economy is significantly stronger, premiums on bank credit default swaps have fallen by more than half of their 2009 levels, and other measures of bank risk have also declined substantially. More than 90 percent of the public capital injections into the banking system have been repaid, and the Feds liquidity programs and the FDIC's temporary guarantees for uninsured business deposits and bond issues have largely been wound down.
The results of the most recent stress tests and capital planning evaluations continue to reflect improvement in banks' condition. Projected aggregate loan losses under this year's so-called severely adverse scenario were 7 percent lower than last year, in part because the riskiness of banks' portfolios continues to decline. Over the past four years, the aggregate tier 1 common equity ratio of the 18 firms that underwent the recent tests has more than doubled, from 5.6 percent of risk-weighted assets at the end of 2008 to 11.3 percent at the end of 2012, a net gain of nearly $400 billion in tier 1 common equity, to almost $800 billion at the end of 2012. Bernanke said that even under the severely adverse scenario of the latest stress test, the estimate of these firms' post-stress tier 1 common capital ratio is more than 2 percentage points higher than actual capital levels at the end of 2008. In addition, a majority of the 18 CCAR firms already meet new internationally agreed-upon capital standards and the others are on track to meet these requirements as they are phased in.
The medium-sized and smaller banks not included in CCAR have also improved considerably. Their aggregate tier 1 common equity stood at 12.4 percent of risk-weighted assets in the fourth quarter of 2012, more than 4 percentage points higher than at the end of 2008.
The financial crisis underlined the importance of maintaining adequate liquidity and here too, the news is mostly positive, as both larger and smaller banks have generally improved their liquidity position from pre-crisis levels. However, continued improvement is still needed in the area of liquidity and funding and supervisors will continue to press banks to reduce further their dependence on wholesale funding and further strengthen their ability to identify, quantify, and manage their liquidity risks.
The main benefits of stress tests for supervision have not changed much since the SCAP was first conducted. First they complement standard capital ratios by adding a more forward-looking perspective and by being more oriented toward protection against so-called tail risks. The fact that they look horizontally across banks promotes more-consistent supervisory standards and reveals how significant economic or financial shocks would affect the largest banks collectively as well as individually. Finally the disclosures of stress test results promote transparency by providing the public consistent and comparable information about banks' financial conditions.
The basic methodology has not changed materially since the first test. Fed economists create an adverse hypothetical macroeconomic scenario, estimate each bank's expected losses and revenues, and use them to project post-stress capital levels and ratios. For the firms with the largest trading activities the basic scenario is supplemented with a market-shock scenario incorporating severe market turbulence similar to that of the latter half of 2008. The Fed has continued to refine the formulation of the hypothetical scenarios that form the basis of the stress tests and now incorporate not only the typical consequences of a severe recession but also other adverse developments such as an exceptionally large decline in house prices
The Fed has also improved its tools for estimating projected bank losses, revenues, and capital under alternative scenarios and considerable progress has been made in data collection and in the development of independent supervisory models. In the most recent SCAP the Fed collected and analyzed loan- and account-level data on more than two-thirds of the $4.2 trillion in accrual loans and leases projected to be held by the 18 firms. That data includes borrower, loan, and collateral information on more than 350 million domestic retail loans, including credit cards and mortgages, and more than 200,000 commercial loans. More than 40 models are used to project how categories of bank losses and revenues would likely respond in hypothetical scenarios. These improvements in data and models have increased the Fed's ability to distinguish risks within portfolios and, Bernanke said, "Are bringing us close to the point at which we will be able to estimate, in a fully independent way, how each firm's loss, revenue, and capital ratio would likely respond in any specified scenario."
SCAP allows supervisors to focus on banks' internal capital planning practices. Banks with assets of $50 billion or more are required to submit annual capital plans to the Fed. While regulatory minimums and supervisory expectations provide floors for acceptable capital levels, the firms and their boards of directors are responsible for assessing their own capital needs over and above the minimums. In CCAR, the qualitative assessment of a firm's capital planning is integrated with the quantitative results of both the supervisory and company-run stress tests.
Bernanke said the Fed continues to increase the transparency of the stress testing process, the results of the exercises, and its assessments of banks' capital planning. The disclosures of traditionally confidential supervisory information in the first SCAP was intended to restore public confidence and the Fed now disclosures even more information. For example in the last release the Fed disclosed for the first time whether it had objected to each firm's capital plan. The disclosures by banks give investors and analysts an alternative perspective on the test results and help them form judgments about banks' appetites for risk and their risk-management practices. "The disclosure of stress test results and assessments provides valuable information to market participants and the public, enhances transparency, and promotes market discipline."
Since the first stress test Dodd-Frank has widened the scope to all bank holding companies with $50 billion or more in total consolidated assets and to nonbank financial companies designated by the Financial Stability Oversight Council as systemically important. The 11 additional companies affected will be subject to DFAST and CCAR for the first time next year. The Dodd-Frank Act also requires that institutions with between $10 billion and $50 billion in assets conduct their own stress tests. (Community banking organizations with $10 billion or less in total assets are exempted from this requirement.)
Bernanke said stress testing has a number of important benefits as a supervisory tool. From a microprudential perspective, CCAR allows supervisors to assess both whether banks hold enough capital and whether they are able to rapidly and accurately determine their risk exposures.
From a macroprudential perspective, the Fed can see how a particular risk or combination of risks might affect the banking system as a whole, useful as a tool to better monitor and evaluate potential systemic risks. For example, staff tends to rely on horizontal examinations and comparative studies, as opposed to firm-by-firm assessments, use multidisciplinary, specialized teams to supplement the work of on-site examiners; and increase the use of modeling and quantitative methods, using data drawn from different institutions and time periods.
Bernanke said that notwithstanding the demonstrated benefits, comprehensive stress testing also presents challenges. For example that Fed has chosen not to publish the full specification of the models it uses for estimation and banks complain that these models are a "black box," frustrating their efforts to anticipate supervisory findings. The Fed agrees that banks need to generally understand how the models work and be confident they are valid and accurate but is trying to balance the need for more transparency with the worry that increased disclosure of the modeling would cause firms to downplay their independent risk-management systems and adopt supervisory models instead. While this would certainly make it easier to "pass" the stress tests Bernanke said all models have their blind spots and such a "model monoculture" that would be susceptible to a single, common failure.
Stress scenarios also cannot encompass all of the risks that banks might face. Some operational risk losses, such as expenses for mortgage put-backs, are incorporated in stress test estimates but there are operational, legal, and other risks that are specific to individual companies and banking firms must consider the potential for losses from other classes of risks as systematically as possible.
Bernanke concluded his remarks by saying, "One of the most important aspects of regular stress testing is that it forces banks (and their supervisors) to develop the capacity to quickly and accurately assess the enterprise-wide exposures of their institutions to diverse risks, and to use that information routinely to help ensure that they maintain adequate capital and liquidity. The development and ongoing refinement of that risk-management capacity is itself critical for protecting individual banks and the banking system, upon which the health of our economy depends.
