This week The Clearing House published a new research note — Fed’s versus banks’ own models in stress testing: what have we learned so far?
The U.S. supervisory stress tests rely almost exclusively on the Fed’s own models to generate the binding projections of banks’ post-stress regulatory capital ratios. In contrast, jurisdictions supervised by the Bank of England and the European Central Bank allow banks’ own models to play a key role in generating the projections of stressed loan losses and net revenues. In these jurisdictions supervisory models are only used to challenge banks’ own results.
One reason commonly proffered for the U.S. approach is that banks knowingly understate losses and overstate revenues in order to boost returns or gain competitive advantage. Although the Fed also reviews and approves every bank stress testing model, this process has been deemed insufficient.
Of course, there are significant downsides to using the Federal Reserve’s models to set capital charges. The process is opaque and seemingly inconsistent with the Administrative Procedure Act. As a matter of accuracy, the Federal Reserve’s models are cruder and lack the wealth of historical data that the bank models employ. Finally, the use of the same models for the entire industry risks concentrating risk in asset classes favored by those models. While the Federal Reserve has used this possibility to justify keeping the models secret, our prior research shows that this phenomenon is already occurring. Thus, the current system appears to be imposing heavy costs based on the putative benefit of preventing banks from using their models to willfully understate risk.
The new research note analyzes the results of the supervisory stress tests obtained using the Fed’s models relative to the results obtained using banks’ own models under the Dodd-Frank Act stress tests over the past 5 years.
The analysis finds:
- Banks’ projections of pre-tax net income are on average more pessimistic than the Fed’s projections, particularly for revenues under stress.
- The Fed projects that asset and loan balances grow over the stress horizon, with a resulting increase in risk-weighted assets, while banks assume that their balance sheets shrink due to a decrease in loan demand during a severe recession, with a resulting decrease in risk-weighted assets.
- Lastly, the disagreement between banks’ own projections and the Fed’s are persistent but only predictable in part.
These results imply that if the stress tests were to impose a simple assumption and let balance sheets and risk-weighted assets remain constant over the severely adverse scenario, banks’ own DFAST results would yield a significantly more pronounced decline in the common equity tier 1 ratio under stress.
This research appears to support the notion that there should be more use of banks’ own models in setting minimum requirements under the U.S. supervisory stress tests. The use of banks’ own models would reduce uncertainty regarding banks’ capital requirements, boost innovation in risk management at banks and improve financial stability by eliminating the risk of the industry coalescing around the same models as those used by the Fed. Of course, one could argue that if bank models were to play a larger role, the banks would have a greater incentive to change them in order to understate losses or overstate revenues (and camouflage this action from their compliance and audit departments, the Federal Reserve’s own model reviewers as well as analysts and investors, all of whom would presumably notice a material change from what is now a five year history of bank projections). We do not evaluate this possibility, but simply note that on the evidence at hand, it appears that bank models are not more forgiving than the Federal Reserve’s.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.