Dynamic stress testing — or using econometric models to forecast a financial institution’s income and regulatory capital through hypothetical economic shocks — is a good idea. But the Federal Reserve’s rules need to keep improving to make them less onerous and more reliable.
Fortunately, the Fed seems to agree, having taken several recent steps in that direction, among them the March 28 publication of 80 pages of new data explaining model assumptions and analytics. Vice Chairman Randal Quarles speaks openly about the issues that stress tests raise, which in itself is a breath of fresh air. Still, while the Fed has now disclosed more than it ever has about its stress tests since he was appointed, the information is not as granular as institutions would like, and timing of important assumptions still seems to be an issue. The delivery of this latest data came just one week before banks were scheduled to make their annual Comprehensive Capital Analysis and Review, or CCAR, submissions.
That said, it’s worth giving the Fed credit for signaling that it appreciates the relationship between risk management and profitability, and for taking the first steps to make its stress testing process more transparent and efficient. While some may feel that it is of no consequence if large banks are inconvenienced by cumbersome capital and stress testing requirements, they couldn’t be more misinformed. Stress test requirements directly impact the economy and the wallets of every American.
Capital requirements and stress tests assign risk to each asset on the books of a bank. Those risk weightings determine how much capital an institution must hold, which in turn influences how credit is allocated throughout the country.
In addition, economic and timing uncertainties in the process cause banks to hold capital buffers beyond what the law requires just to avoid being out of compliance when the assumptions of the model shift, as they can each year. Every extra dollar of capital that is locked away in a bank’s vault to pad this surplus directly reduces multiples of that dollar that could otherwise be lent to American consumers and businesses.