Quarles: Stress tests will continue, as will the qualitative assessment (in regular supervision)

More stress test model disclosures to come in 2020 and after

Noting that banks have “significantly improved” their risk-management and capital planning processes since the advent of the Comprehensive Capital Analysis and Review (CCAR), the Federal Reserve Board’s top supervisory official on Tuesday said the “qualitative” analysis previously featured in this process will, for most banks, be incorporated into the Fed’s regular supervisory practices.

“Large banks have improved the methods they use to identify their unique risks, now use sound practices for identifying and addressing model weaknesses, and have strong processes in place to evaluate their capital positions on a forward-looking basis,” Federal Reserve Board Vice Chairman for Supervision Randal Quarles said during a keynote message at the Fed’s stress testing conference in Boston. “While we continue to perform a qualitative assessment and ensure that progress is retained, the improvements led the Federal Reserve to conclude that for most banks this assessment can be incorporated into our regular supervisory practices.”

Quarles pointed to the evolution of the qualitative assessment based on experience of the past 10 years of stress testing “and in particular, the great improvement in risk management by large banks and the cumulative effect of the Fed’s improved supervision of large institutions.” He said that for stress testing to remain effective, it must respond to changes in the economy, the financial system, and risk-management capabilities.

He also said that financial firms have more than doubled their capital since the first round of stress tests in 2009, with the common equity of the largest 18 firms growing by more than $650 billion.

Quarles said recent changes, and proposed changes, to the Fed’s stress testing are aimed at making CCAR more transparent and simple “and to feature less unnecessary volatility.” The guiding principles of these changes include transparency, simplicity, and volatility.

Regarding transparency, Quarles said this year’s disclosures on two key stress models will be followed with disclosures on two additional models in 2020, “and each year thereafter until we have provided transparency about all our stress test models.” As for simplicity, the Fed official pointed to the current proposal, the stress capital buffer, which he said would simplify the Fed’s large bank capital rule by integrating the stress testing process with traditional regulatory capital rules.

Regarding volatility, the Fed governor noted the distinction between what he sees as “useful variation” in stress tests, or exploration of salient risks, vs. the “less useful,” or unexpected swings in capital requirements “that don’t have any particular relationship to changing risks at individual firms.” He also noted the volatility that comes from a bank having to do its capital planning in advance of seeing stress test results.

“In distinguishing useful from less useful volatility, one option to address the year-over-year volatility of the tests would be to average the results of the tests from the previous year or years. This would not affect the overall stringency of the tests but, mathematically, would mean that no single year could have an outsized influence on the amount of capital that a bank is required to maintain,” Quarles said. “The potential downsides to this approach include the reduced risk sensitivity that a bank may experience to a particular test and potential technical challenges associated with changes to a bank’s balance sheet and earnings. Bearing in mind these potential challenges, I believe more thinking and discussion of this issue would be fruitful.”

Regarding the remaining concern, Quarles said he believes it “more rational and logical for firms to be able to plan for their capital needs with the benefit of the results of our tests. Given the huge strides that the banks have made in their capital planning and in meeting our expectations, I view the risk of banks backsliding in this regard to be minimal because it would be evident in the next test.”

“Stress Testing: A Decade of Continuity and Change,” speech by Fed Vice Chairman for Supervision Quarles during research conference at Federal Reserve Bank of Boston