In this note we propose a method to assess the severity of stress test scenarios. An objective way of assessing scenario severity, such as we propose here, and an intended standard for that measure, would make the Federal Reserve more transparent to banks they supervise, investors and the public with respect to the changes in stress-test severity over time. In addition, the increased accountability will likely help reduce the excessive variability in capital requirements of large banks. Reducing unnecessary volatility in stress-test requirements is particularly important in the context of the Federal Reserve’s new proposal to integrate the stress tests with ongoing capital requirements via the stress capital buffer. Under that proposal, a stress capital buffer is added to the minimum capital requirement and it is determined using the peak-to-trough decline in the regulatory capital ratio under stress. We also propose several key steps for the Federal Reserve to adopt for scenario transparency including using its own models to determine the impact of a crisis and articulating an intended severity standard. While some may argue that more transparency around the stress tests scenarios would make stress tests more predictable and potentially give the supervised institutions an ability to game the system, this note shows that it would instead reduce the variability of capital requirements over time, thereby improving the efficiency of credit allocation in the U.S. economy and strengthen financial stability.
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