Fed’s Quarles outlines changes made to analysis of stress testing results, to be released next week

While stress test results scheduled to be released next week will be based on a scenario developed before the financial impact of the coronavirus crisis was evident, the analysis the Fed performs of the results will incorporate three “downside risk paths” for the economy that have emanated from the pandemic, the top supervisor for the Federal Reserve said Friday.

However, Federal Reserve Board Vice Chair for Supervision Randal Quarles said that analysis will not provide risks to specific banking firms.

Quarles made the remarks before the group Women in Housing and Finance, in Washington, D.C. in a speech aimed at outlining the stress testing program by the central bank is adapting to the financial impact of the coronavirus pandemic. The results of the most recent stress tests, which began in March and ran through April, are scheduled to be released Thursday (June 25).

He said that the test results would be based on a scenario developed in February, before the coronavirus crisis in the U.S. became apparent, and would reflect bank balance sheets as of December. “To be more precise, this portion of our disclosure, based on the results of the February 2020 scenario, will be identical in all material ways to last year’s stress test disclosure,” he said.

However, the Fed vice chairman told the group that the larger issue facing the agency in interpreting stress-test results is the uncertainty about the course of the coronavirus crisis (which he called the “COVID event”) and the economy.

“The range of plausible forecasts is high and continues to shift,” Quarles said. “We don’t know about the pace of reopening, how consumers will behave, or the prospects for a new round of containment. There’s probably never been more uncertainty about the economic outlook. Although our policies on stress testing emphasize the value of not increasing capital requirements under stress and thus exacerbating a downturn, our first priority must be—and is—to understand the implications of quite plausible downside scenarios from our current position for bank capital.”

To understand the implications of the pandemic on the banks, Quarles said, it is using a “sensitivity analysis” for the test results that considers three distinct downside risks for the economy. Those are:

  • A rapid V-shaped recovery that regains much of the output and employment lost by the end of this year;
  • A slower, more U-shaped recovery in which only a small share of lost output and employment is regained in 2020;
  • A W-shaped double dip recession with a short-lived recovery followed by a severe drop in activity later this year due to a second wave of containment measures.

Quarles stressed that the scenarios are not forecasts by himself or the Fed, but are only “plausible scenarios” spanning range of where many private forecasters think the economy may be headed.

“Our sensitivity analysis is different from our normal use of a severely adverse scenario in several ways,” Quarles said. “First, there are three possible paths instead of one because we must consider this range of outcomes. While we retained the basic structure of the February 2020 scenario, we swapped out a few key variables such as the unemployment rate, change in economic output, and Treasury bill rates.”

He said the Fed also didn’t follow its scenario design policy statement in formulating the three alternative paths. “We chose rough approximations of economic paths rather than detailed scenarios, which means that the usual set of detailed variable data that we use will not be available,” he said.

He noted that the while the analysis will be still based on year-end 2019 data, it will have targeted adjustments to account for the most material changes to banks’ balance sheets in the first quarter related to the COVID event, such as sizeable credit-line drawdowns by corporations.

“By giving the firms their effective capital buffer requirement for the coming year and allowing them to adjust their capital plans to that buffer, the change will result in a more thoughtful assessment of risks,” Quarles asserted. “Once the banks have determined their final capital plans, the Board will publicly release the final capital requirements for each individual firm later this year, before they take effect in the fourth quarter, as planned.”

Federal Reserve Board Vice Chair for Supervision Randal K. Quarles: The Adaptability of Stress Testing