Certain details of the methodologies underlying banking regulators’ 2021 stress test models will be disclosed in March, with firm-level stress test results out in June, the Federal Reserve’s top supervision official said Thursday.
Discussing the role of stress testing during a webcast for the Federal Reserve Bank of Atlanta, Fed Vice Chair Randal Quarles said the methodology disclosure will include information on ranges of loss rates, estimated by using the models, for actual loans held by firms subject to comprehensive capital analysis and review (CCAR); portfolios of hypothetical loans with loss rates estimated by the models; and more detailed descriptions of the models, such as equations and key variables that influence the results of the models.
The disclosure won’t cover everything, Quarles noted, “lest we find ourselves in a ‘model monoculture’ where supervisors and banks converge on the same sets of risks, ignoring other potential problems.”
With the ongoing COVID-19 pandemic as backdrop, this year’s stress testing involves a hypothetical macroeconomic scenario that envisions a severe global recession accompanied by a period of heightened stress in U.S. commercial real estate and corporate debt markets. “As discussed in recent financial stability reports, the current environment presents unique challenges for those asset classes, and our focus on them in the scenarios is consistent with the salient risks they pose to banks,” Quarles said. This scenario layers additional significant stress on top of the stress already absorbed by banks over the past year, he noted, citing a rise back in the unemployment rate to nearly 11% and more than a 50% a decline in stock prices.
Firm-level results of the 2021 stress tests will be released in June, he said, including results from any of the smaller firms not required to undergo a supervisory stress test this year but which opted to do it.
Quarles underscored the importance of stress testing in informing the Fed’s decision making on bank capital and distributions. In addition to the regularly scheduled testing, the Fed last year internally performed a sensitivity analysis that addressed added scenarios and had banks perform a second round of stress testing in December. He said that due to the Fed’s and banks’ actions in response, U.S. bank capital levels rose last year despite substantial increases in loan loss reserves. Quarles said the aggregate common equity ratio across large banks increased from 12% at the end of 2019 to 12.8% at the end of 2020 and that large banks built roughly $90 billion in loan loss reserves.
Looking to the future, Quarles said the Fed “must continue to innovate so that stress testing remains effective” and that in the near term, it must strive to understand the implications of the COVID event on how we measure financial risk. Noting stresses on borrowers – unemployment, cash flow disruptions, and continued economic uncertainty – he said the programs put in place to help those borrowers “are critical for our recovery but will further complicate risk modeling as borrower stress may be obscured by temporary stimulus.”
Quarles noted, for example, the difficulty in discerning whether a borrower who has continued to make loan payments amid the pandemics been able to do so because of stimulus payments or because they have continued to earn income. “Borrowers benefitting from temporary forbearance may or may not be able to resume payments once the forbearance ends,” he added.
“Over the longer term, we must continue to sharpen our thinking around the interrelationships between bank risk and broader changes, such as advancing technologies and growth in non-bank finance. Those forces are undoubtedly altering bank risk, and it will take creative and timely research to understand the implications,” he said. “Our agenda also includes initiatives that could reduce the volatility in the stress test results without sacrificing either their probative value or their rigor. We will continue to explore those possibilities.”
Quarles speech before Atlanta Fed (via webcast)