Decline in bank stress likely to continue as interest rates normalize
Each of the 33 firms participating in DFAST 2020 submitted data as of December 31, 2019, through the FR Y-14M and FR Y-14Q reports in February, March, and April 2020. The $541 billion in total projected losses includes over $100 billion in losses from commercial real estate and residential mortgages, and $120 billion in credit card losses, both higher than the losses projected in last year’s test. The aggregate 2.3 percentage point decline in capital is slightly less than the 2.7 percentage point decline from last year’s test but is comparable to declines projected from the stress test in recent years. The disclosure document includes additional information about losses, including firm-specific results and figures.
Consistent with the stress capital buffer rule, the Federal Reserve no longer includes certain capital actions or the impacts of material business plan changes in its regulatory capital calculation and assumes that a firm’s balances, RWAs, and leverage ratio denominators generally remain unchanged over the projection horizon. 2 In addition, to maintain a consistent capital calculation methodology across all firms, the Federal Reserve limited the use of firms’ projections in the capital calculation. The Federal Reserve projects these components of pre-tax net income using supervisory models that take the Board’s scenarios and firm-provided data as inputs. The projections are based on the assumption that firms’ balance sheets remain unchanged throughout the projection period. Macroeconomic variables used in select supervisory models vary across geographic locations (e.g., by state or by county). The Federal Reserve projects the paths of these variables as a function of aggregate macroeconomic variables included in the Board’s scenarios.
- For the first time, the Board conducted an exploratory market shock on the trading books of the largest banks, testing them against greater inflationary pressures and rising interest rates.
- Bank-specific elements – which, as noted above, are critical to the microprudential policy objectives of the CCAR and DFAST programs – are introduced by using detailed data provided by each participating institution.
- The individual results from the stress test inform a bank’s capital requirements to help ensure a bank could survive a severe recession and financial market shock.
- A disciplined analytical approach to these topics is critical in weighing future design choices, such as those made during the initial implementation of SCAP, CCAR and DFAST stress testing.
Each year, the Federal Reserve has refined both the substance and process of the supervisory stress test, including its development and enhancement of independent supervisory models. The supervisory stress test models may be enhanced to reflect advances in modeling techniques; enhancements in response to model validation findings; incorporation of richer and more detailed data; and identification of more stable models or models with improved performance, particularly under stressful economic conditions. For certain loans, expected losses under the macroeconomic scenario are estimated by projecting the probability of default (PD), loss given default (LGD), and exposure at default (EAD) for each quarter of the projection horizon. The Federal Reserve models most components of PPNR using a suite of models that generally relate specific revenue and non-provision-related expenses to the characteristics of firms and to macroeconomic variables. These include eight components of interest income, seven components of interest expense, six components of noninterest income, and three components of noninterest expense.
Under stress, the aggregate CET1 capital ratio—which provides a cushion against losses—is projected to decline by 2.8 percentage points, from 12.7 percent to 9.9 percent. Supervisory stress testing emerged as a policy solution to address both backward-looking regulatory capital ratios and possible first-mover problems facing banks during periods of stress. Stress tests aren’t a prediction of future events but rather hypothetical exercises intended to assess the robustness of a bank’s resources against various potential future bad outcomes. In this way, they provide additional insight into the true degree of capital adequacy inherent in a bank’s current capital position and the risks embedded in its balance sheet, including its ability to continue to make capital distributions in both reserve balances noninterest expenses and bank performance in the stress tests baseline and stressed economic conditions. The Federal Reserve modified the capital calculation to align the computations with the capital simplification, tailoring, and stress capital buffer rules. Similarly, to align with the tailoring rule, the Federal Reserve no longer includes accumulated other comprehensive income in the calculation of certain firms’ regulatory capital.
To begin, capital ratios are measured separately for individual institutions, with no attempt to capture dynamic interactions, spillovers or specific cross-firm exposures. Similarly, outcomes for the banking sector do not interact dynamically with the macroeconomic scenarios, which are inputs to the calculations. As a result, the calculations are “stand alone” in the sense that the outcomes for any individual institution are independent of those for others in the set of stress-tested firms. Results for the banking system are therefore simply the sum of results for individual institutions, rather than capturing interactions among them.
The Board’s stress tests help ensure that large banks can support the economy during economic downturns. The tests evaluate the resilience of large banks by estimating their capital levels, losses, revenue and expenses under hypothetical scenarios over nine future quarters. Particularly notable is the dramatic decline in the incidence of low adjusted tangible common equity ratio flags (expressed as a share of total assets) in the Eleventh District (Chart 6). The first three measures are commonplace, prominently used for monitoring banks during the savings and loan crisis in the late 1980s and early 1990s and in the Great Recession in the mid to late 2000s. Historically, banks with high shares of risky commercial real estate lending and less stable deposit funding (lacking the steadiness of checking accounts and certificates of deposit, for example) are more likely to fail than other banks, all else equal. Separately, many fast-growing banks have failed because of poor asset and liability management, as their internal controls and oversight lagged growth in assets.
Qualified mortgage interest includes interest and points you pay on a loan secured by your main home or a second home. Your main home is where you live most of the time, such as a house, cooperative apartment, condominium, mobile home, house trailer, or houseboat. You can also treat amounts you paid during the year for qualified mortgage insurance as qualified home mortgage interest.
- The Federal Reserve Board on Thursday released the results of its annual bank stress test, which showed that banks continue to have strong capital levels, allowing them to continue lending to households and businesses during a severe recession.
- The unemployment rate rises by 6.4 percentage points to a peak of 10 percent and economic output declines commensurately.
- The test’s focus on commercial real estate shows that while large banks would experience heavy losses in the hypothetical scenario, they would still be able to continue lending.
- Under each element, large banks would remain above minimum capital requirements in aggregate, with capital ratio declines of 2.7 percentage points and 1.1 percentage points, respectively.
- The $541 billion in total projected losses includes over $100 billion in losses from commercial real estate and residential mortgages, and $120 billion in credit card losses, both higher than the losses projected in last year’s test.
2. Blockchain-Based Financial Tracking and Smart Contracts
While FHLBs’ core business is providing collateralized loans to their members, FHLBs lend in the fed funds market because fed funds loans are highly liquid assets that help FHLBs meet their regulatory liquidity requirements.11,12 FHLBs account for over 90 percent of federal funds lending. They lend cash mostly to foreign banking organizations (FBOs) and to mid-sized to large domestic banks that are subject to the liquidity coverage ratio (LCR).13 The motives behind almost all of these transactions are unrelated to banks’ basic need for liquidity and reserves. Our indicators, therefore, isolate dynamics in another segment of the fed funds market that better reflects such needs for reserves and show how activities in this segment evolve as aggregate reserves become scarce. A final set of design choices affecting how stressed capital ratios are measured involves the actual models that produce the estimates of net income and capital.
4. Implementation Challenges in Diverse Economic Environments
This year’s stress test includes a severe global recession with a 40 percent decline in commercial real estate prices, a substantial increase in office vacancies, and a 38 percent decline in house prices. The unemployment rate rises by 6.4 percentage points to a peak of 10 percent and economic output declines commensurately. The Federal Reserve Board on Thursday released the results of its annual bank stress test, which showed that banks continue to have strong capital levels, allowing them to continue lending to households and businesses during a severe recession. Balance sheet hedge activity done by altering asset and/or liability repricing characteristics or volumes to reduce the entity’s interest rate risk exposure without purchasing derivative hedge instruments such as interest rate swaps or futures.
Appendix A.1.5. Step 5: Risk Adjustment Terms
Also on Thursday, the Board corrected an error with the results for BNP Paribas USA from the June and December 2020 stress tests. As a result, the projected pre-provision net revenue, projected pre-tax net income, and projected capital ratios were corrected. The Federal Reserve Board on Thursday released the results of its annual bank stress tests, which showed that large banks continue to have strong capital levels and could continue lending to households and businesses during a severe recession.
The exploratory analysis is distinct from the stress test, exploring additional hypothetical risks to the broader banking system. It includes a severe global recession with a 40 percent decline in commercial real estate prices, a substantial increase in office vacancies, and a 36 percent decline in house prices. The unemployment rate rises nearly 6-1/2 percentage points to a peak of 10 percent, and economic output declines commensurately. How can research help address these issues and, more generally, improve the overall supervisory stress testing regime? I want to suggest two general areas of research – one tactical and the other much bigger picture and strategic.
FEDS Notes
Further, examining how lending has been impacted in the current economic environment of strong economic activity does not quite provide the full picture, as it does not address whether these programs will be successful in mitigating spillovers, credit contractions and other negative outcomes during periods of stress. In assessing the costs and benefits of stress testing and other post-crisis regulations, it seems critical to assess not just current impact but outcomes over the cycle – something that is a challenge during a period of recovery and growth. Gains and losses on HFS C&I and CRE loans are estimated using a model specific to those asset classes. The level of overall bank stress nationally and in the Eleventh District has declined significantly since 2023, although overall it remains somewhat elevated relative to prepandemic levels. Given that bank stress has decreased under the so-called higher-for-longer regime of ongoing, relatively high interest rates, further declines are likely as interest rates fall.
The banks in this year’s test hold roughly 20 percent of the office and downtown commercial real estate loans held by banks. The large projected decline in commercial real estate prices, combined with the substantial increase in office vacancies, contributes to projected loss rates on office properties that are roughly triple the levels reached during the 2008 financial crisis. Total losses were largely driven by more than $450 billion in loan losses and $100 billion in trading and counterparty losses. Additionally, the aggregate 2.7 percent decline in capital is slightly larger than the 2.4 percent decline from last year’s test but is comparable to recent years.
The results of the Federal Reserve Board’s annual bank stress test showed that while large banks would endure greater losses than last year’s test, they are well positioned to weather a severe recession and stay above minimum capital requirements. Additionally, the Board published aggregate results from its first exploratory analysis, which will not affect bank capital requirements. In addition, the Federal Reserve re-estimated its full suite of PPNR models on an expanded sample, re-specifying models based on performance testing.
All banks tested remained above their minimum capital requirements, despite total projected losses of $612 billion. Under stress, the aggregate common equity capital ratio—which provides a cushion against losses—is projected to decline by 2.7 percentage points to a minimum of 9.7 percent, which is still more than double the minimum requirement. In large part, the focus on individual institutions – the “stand-alone” design choice – accounts for this outcome.
1. Comprehensive Risk Modeling
Still, these moves reinforce that close monitoring of repo market conditions is warranted.21In contrast, the elasticity of the EFFR spread to changes in the TGA, shown in orange, did not exhibit substantial sensitivity to TGA changes in 2019 until right before the September spike. The relative sensitivity of repo market rates makes this elasticity a particularly useful early warning signal of reserve scarcity. Below, we discuss factors that may make repo rates more informative than the EFFR in detecting early signals of reserve scarcity. In that regard, the drive for precision and accuracy at the individual institution level – and the resulting complexity of the supervisory models and extensive firm-specific data inputs needed to run the models – has created other challenges.
The guiding assumption is that a bank’s balance sheet and the nature of its exposures do not change over the stress test horizon. After many years of SCAP and CCAR stress tests, the empirical approach embedded in the calculations might feel pre-ordained, but in fact there were many design choices made along the way. These include the focus on regulatory capital ratios, the horizon of the stress test and the calculation of the maximum impact of the stress test within this horizon. It’s helpful to review these design choices in light of the goals of the supervisory stress testing regime and to highlight which banking sector vulnerabilities are well addressed, and not so well addressed, by the tests.