Bernanke Lauds Role of Bank Stress Tests

Federal Reserve Chairman Ben Bernanke, speakingrnat a Federal Reserve Bank of Atlanta sponsored conference on Monday said thatrnthe use by the Fed of supervisory stress tests has helped the banking systemrnrecover and along with it the overall economy. rnMethodologically, he said, stressrntests are forward looking and focus on unlikely but plausible risks, as opposedrnto “normal” risks and thus complement more conventional capital andrnleverage ratios.  They have evolved considerable since they werernfirst conducted in 2009 in the wake of the near collapse of several major banksrnthe previous year.  </p

Bernanke said that, like all bureaucracies, thernFederal Reserve “has an unfortunate tendency to creaternacronyms.”  Those relevant to hisrnpresentation are the basic test, the Supervisory Capital Assessment or SCAP.  The tests required by the Dodd-Frank Act,rncalled DFAST, quantitatively assess how bank capital levels would fare inrnstressful economic and financial scenarios. rnThe Comprehensive Capital Analysis and Review, or CCAR, combines thernquantitative results from the stress tests with more-qualitative assessments ofrnthe capital planning processes used by banks. </p

The first SCAP provided anxiousrninvestors with credible information about prospective losses at banks, helped restorernconfidence in the banking system and enabled its successful recapitalization.  Today, Bernanke said, the economy isrnsignificantly stronger, premiums on bank credit default swaps have fallen byrnmore than half of their 2009 levels, and other measures of bank risk have alsorndeclined substantially. More than 90 percent of the public capital injections intornthe banking system have been repaid, and the Feds liquidity programs and thernFDIC’s temporary guarantees for uninsured business deposits and bond issuesrnhave largely been wound down. </p

The results of the most recentrnstress tests and capital planning evaluations continue to reflect improvementrnin banks’ condition.  Projected aggregaternloan losses under this year’s so-called severely adverse scenario were 7rnpercent lower than last year, in part because the riskiness of banks’rnportfolios continues to decline. Over the past four years, the aggregate tier 1rncommon equity ratio of the 18 firms that underwent the recent tests has morernthan doubled, from 5.6 percent of risk-weighted assets at the end of 2008 to 11.3rnpercent at the end of 2012, a net gain of nearly $400 billion in tier 1 commonrnequity, to almost $800 billion at the end of 2012.   Bernanke said that even under the severelyrnadverse scenario of the latest stress test, the estimate of these firms’rnpost-stress tier 1 common capital ratio is more than 2 percentage points higherrnthan actual capital levels at the end of 2008.  In addition, a majority of the 18 CCAR firmsrnalready meet new internationally agreed-upon capital standards and the othersrnare on track to meet these requirements as they are phased in. </p

The medium-sized and smaller banks notrnincluded in CCAR have also improved considerably.  Their aggregate tier 1 common equity stood atrn12.4 percent of risk-weighted assets in the fourth quarter of 2012, more than 4rnpercentage points higher than at the end of 2008. </p

The financial crisis underlined the importancernof maintaining adequate liquidity and here too, the news is mostly positive, asrnboth larger and smaller banks have generally improved their liquidity positionrnfrom pre-crisis levels. However, continued improvement is still needed in thernarea of liquidity and funding and supervisors will continue to press banks tornreduce further their dependence on wholesale funding and further strengthenrntheir ability to identify, quantify, and manage their liquidity risks. </p

The main benefits of stress testsrnfor supervision have not changed much since the SCAP was first conducted.  First they complement standard capital ratiosrnby adding a more forward-looking perspective and by being more oriented towardrnprotection against so-called tail risks. The fact that they look horizontallyrnacross banks promotes more-consistent supervisory standards and reveals howrnsignificant economic or financial shocks would affect the largest banksrncollectively as well as individually. Finally the disclosures of stress testrnresults promote transparency by providing the public consistent and comparablerninformation about banks’ financial conditions. </p

The basic methodology has notrnchanged materially since the first test. rnFed economists create an adverse hypothetical macroeconomic scenario, estimaterneach bank’s expected losses and revenues, and use them to project post-stressrncapital levels and ratios.  For the firmsrnwith the largest trading activities the basic scenario is supplemented with arnmarket-shock scenario incorporating severe market turbulence similar to that ofrnthe latter half of 2008. The Fed has continued to refine the formulation of thernhypothetical scenarios that form the basis of the stress tests and now incorporaternnot only the typical consequences of a severe recession but also other adverserndevelopments such as an exceptionally large decline in house prices</p

The Fed has also improved its toolsrnfor estimating projected bank losses, revenues, and capital under alternativernscenarios and considerable progress has been made in data collection and in therndevelopment of independent supervisory models.  In the most recent SCAP the Fed collected andrnanalyzed loan- and account-level data on more than two-thirds of the $4.2rntrillion in accrual loans and leases projected to be held by the 18 firms.  That data includes borrower, loan, andrncollateral information on more than 350 million domestic retail loans,rnincluding credit cards and mortgages, and more than 200,000 commercial loans.   Morernthan 40 models are used to project how categories of bank losses and revenuesrnwould likely respond in hypothetical scenarios. These improvements in data andrnmodels have increased the Fed’s ability to distinguish risks within portfoliosrnand, Bernanke said, “Are bringing us close to the point at which we will bernable to estimate, in a fully independent way, how each firm’s loss, revenue,rnand capital ratio would likely respond in any specified scenario.” </p

SCAP allows supervisors to focus onrnbanks’ internal capital planning practices. rnBanks with assets of $50 billion or more are required to submit annualrncapital plans to the Fed. While regulatory minimums and supervisoryrnexpectations provide floors for acceptable capital levels, the firms and theirrnboards of directors are responsible for assessing their own capital needs overrnand above the minimums.  In CCAR, the qualitativernassessment of a firm’s capital planning is integrated with the quantitativernresults of both the supervisory and company-run stress tests. </p

Bernanke said the Fed continues tornincrease the transparency of the stress testing process, the results of thernexercises, and its assessments of banks’ capital planning. The disclosures of traditionallyrnconfidential supervisory information in the first SCAP was intended to restorernpublic confidence and the Fed now disclosures even more information.  For example in the last release the Fed disclosedrnfor the first time whether it had objected to each firm’s capital plan.  The disclosures by banksrngive investors and analysts an alternative perspective on the test results and helprnthem form judgments about banks’ appetites for risk and their risk-managementrnpractices.  “The disclosure of stressrntest results and assessments provides valuable information to marketrnparticipants and the public, enhances transparency, and promotes marketrndiscipline.” </p

Since the first stress test Dodd-Frankrnhas widened the scope to all bank holding companies with $50 billion or more inrntotal consolidated assets and to nonbank financial companies designated by the FinancialrnStability Oversight Council as systemically important. The 11 additionalrncompanies affected will be subject to DFAST and CCAR for the first time nextrnyear. The Dodd-Frank Act also requires that institutions with between $10rnbillion and $50 billion in assets conduct their own stress tests. (Communityrnbanking organizations with $10 billion or less in total assets are exempted fromrnthis requirement.)  </p

Bernanke said stress testing has arnnumber of important benefits as a supervisory tool. From a microprudentialrnperspective, CCAR allows supervisors to assess both whether banks hold enoughrncapital and whether they are able to rapidly and accurately determine theirrnrisk exposures.  </p

From a macroprudential perspective, thernFed can see how a particular risk or combination of risks might affect thernbanking system as a whole, useful as a tool to better monitor and evaluaternpotential systemic risks. For example, staff tends to rely on horizontalrnexaminations and comparative studies, as opposed to firm-by-firm assessments, usernmultidisciplinary, specialized teams to supplement the work of on-siternexaminers; and increase the use of modeling and quantitative methods, usingrndata drawn from different institutions and time periods. </p

Bernanke said that notwithstandingrnthe demonstrated benefits, comprehensive stress testing also presentsrnchallenges.  For example that Fed has chosenrnnot to publish the full specification of the models it uses for estimation andrnbanks complain that these models are a “black box,” frustrating theirrnefforts to anticipate supervisory findings. The Fed agrees that banks need torngenerally understand how the models work and be confident they are valid andrnaccurate but is trying to balance the need for more transparency with the worryrnthat increased disclosure of the modeling would cause firms to downplay their independentrnrisk-management systems and adopt supervisory models instead.   While this would certainly make it easier to “pass”rnthe stress tests Bernanke said all models have their blind spots and such a “modelrnmonoculture” that would be susceptible to a single, common failure. </p

Stress scenarios also cannotrnencompass all of the risks that banks might face. Some operational risk losses,rnsuch as expenses for mortgage put-backs, are incorporated in stress testrnestimates but there are operational, legal, and other risks that are specificrnto individual companies and banking firms must consider the potential forrnlosses from other classes of risks as systematically as possible. </p

Bernanke concluded his remarks byrnsaying, “One of the most important aspects of regular stress testing is that itrnforces banks (and their supervisors) to develop the capacity to quickly andrnaccurately assess the enterprise-wide exposures of their institutions torndiverse risks, and to use that information routinely to help ensure that theyrnmaintain adequate capital and liquidity. The development and ongoing refinementrnof that risk-management capacity is itself critical for protecting individualrnbanks and the banking system, upon which the health of our economy depends.

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