The introduction of “multiple exploratory scenarios” in bank stress testing was supported by the Federal Reserve’s top supervisor in a speech Thursday before a research conference audience.
Federal Reserve Board Vice Chair for Supervision Michael Barr advocated the use of multiple exploratory scenarios in stress tests, which he said would help improve understanding of risk in the banking system.
Barr said that — both for the broader macroeconomic scenario and the global market shock for trading banks — the multiple scenarios would be beneficial for supervising potential risks on bank balance sheets. “These continued adjustments will help to ensure, consistent with the original intent of the Dodd-Frank Act, that the stress test remains a powerful and relevant tool for assessing whether large banks are resilient and our financial system is robust,” he said.
Under current law, large banks are required to conduct an annual stress test to determine whether those banks have sufficient capital to absorb losses under adverse economic conditions. However, Barr told the Stress Test Research Conference at the Federal Reserve Bank of Boston, that the current stress test has up to three limitations:
- It uses a single scenario test focused on a credit-driven recession and a single global market shock to test a bank’s financial condition.
- Models developed for the tests (which are validated by a group of experts outside of the Fed’s testing program) “are generally trained on historical data and therefore may not be robust to structural breaks, such as a once-in-a-lifetime pandemic, or important changes in technology.”
- By using scenarios that test for the same underlying risks year after year, banks could be disincentivized from investing in their own risk management as the test becomes predictable, and may encourage concentration across the system in assets that receive comparably lighter treatment in the test.
“Exploratory stress test scenarios could mitigate these and other risks,” Barr claimed. “The goal of stress testing should be to provide sufficient coverage of the types of severe but plausible scenarios that could adversely impact a bank’s operations, and the combination of scenarios and shocks should be curated to achieve this goal.”
Barr said the Fed is developing both exploratory macroeconomic scenarios and exploratory market shocks for next year’s stress test. He said an exploratory scenario would not be used to set a firm’s stress capital buffer requirement. “Instead, the exploratory scenarios will be used to inform the board’s supervisory assessments of firms’ risk management and our understanding of different risks in the banking system,” he said.