The Fed is likely to release the scenarios that it will use in the 2019 stress tests at the end of this month. Last year we published a blog post (“A Transparent Method for Judging the Severity of Macroeconomic Stress Scenarios,” Covas and Nelson, August 17, 2018) and a research note (“A Proposal to Improve the Transparency of Stress Scenarios,” Covas, November 13, 2018) that describe a simple way the Fed can measure the severity of a stress scenario. In particular, we described how the Fed could estimate the impact of the scenario on aggregate measures of bank performance such as loan loss provisions, pre-provision net revenue, and return-on-assets, and compare that impact to alternative scenarios or historical episodes.
Accurate measurement of the stress-test scenario severity is important because the stress scenario is a key determinant of the overall stringency of a stress test and therefore an important determinant of banks’ capital requirements. For instance, last year’s stress scenario was the most severe to date resulting in a 4.4. percentage point decline in aggregate common equity tier 1 ratios at the banks that participated in the stress tests—the largest ever and more than 1 percentage point higher than DFAST 2017.
We also suggested that the Fed calibrate its stress test scenario so that it is roughly as severe as the 2007-2009 financial crisis, which was the most severe recession the U.S. has experienced since WWII.
While we still think calibrating to the crisis is a good idea, today we are merely expressing a hope that the Fed is measuring and considering the stressfulness of the scenario that it proposes. As we’ve recommended, the Fed could ask the following, for example: “How does the severity of this scenario compare with past scenarios? How does the severity of this scenario compare with the crisis?” “How likely is this scenario?” It could even share the answers with the public, but at a minimum, we hope it is considering the answers to these questions internally.
We will share our answers to these questions soon after the scenario is released.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.
