"Stress Testing: What's Inside the Black Box?"
Chairman Barr, Ranking Member Foster, Members of the Subcommittee, thank you for the opportunity to testify today. Stress tests have played an important role in our country's financial history. In 2009,
At the time of the crisis-era stress test, I was a
I would like to make four points about the state of
* Supervisory stress tests should be countercyclical.
* Stress tests should use multiple scenarios.
* Stress tests are part of a broader regulatory and supervisory toolkit.
* Transparency can be a double-edged sword.
First, supervisory stress tests should be countercyclical.
In a 2019 paper, my coauthor and I discussed the difference between stress testing in "war time," during a financial crisis, and "peace time," when conditions have eased. n1 At the time, we observed that stress tests that influence capital requirements will inevitably introduce some volatility into capital planning. And bankers will always raise that concern. But today, five years later, after various changes to the tests and a significant increase in disclosures, we face the opposite risk--that the stress tests have become too predictable.
Regulators must keep their guard up during peace time--during those long periods of financial calm when the possibility of a banking crisis and its associated costs appear remote. Stress scenarios can appear fanciful to bankers and regulators whose careers may have begun some time since the last crisis--or, more cynically, whose remuneration is linked to short-term profit metrics as opposed to long-run viability and hedging tail risks. To be effective, stress test scenarios must be sufficiently rigorous and they must have countercyclical elements.
Certain aspects of our political process tend to favor procyclicality, the letting down of our guard during peace time. When bad things happen, we tighten rules, we strengthen risk monitoring, we chastise supervisors. But over some years, economies recover, financial metrics recover, people in responsibility turn over. The regulated are empowered and voices of caution are dimmed. There is the risk that stress testing could become less rigorous over time, or the risk that the rigor of stress testing could vary from one administration to the next. That's what happened in 2018. With regulatory tailoring, the number of banks subject to the stress tests was significantly reduced. Other aspects of the process were also eased.
As an aside, regulatory tailoring of course eased a number of other prudential standards for large banks, not just stress tests. Along those lines, I published a series of blogs last year analyzing the question: Did regulatory tailoring have anything to do with the failure of
It's probably no coincidence that the global financial crisis of 2008-09 is now around the same distance from us as the savings and loan crisis was in the mid-2000s, the last time there was so much pressure to ease bank regulation.
Second, stress tests should use multiple scenarios.
Financial crises tend to emanate from unexpected places. Many have argued for multiple scenarios in
Other advanced-economy supervisors have introduced diverse scenarios and methodologies. The
In short, the US innovated the use of supervisory stress tests during the 2008-09 crisis. Early efforts in other jurisdictions didn't measure up to ours. But in later years the innovation was elsewhere, as ours until recently remained static.
Stress tests are part of a broader regulatory and supervisory toolkit.
Of course, stress tests aren't the right tool for every risk. Some have argued the
Francisco may have been talking his book, but he has a point. In 2020, the
US regulators initially worked with the
The lesson is that supervisors need many tools in their toolkit. A lesson that was again driven home recently when supervisors rejected several big banks' resolution plans.
Fourth, transparency can be a double-edged sword.
Too much transparency can be a bad thing. My colleague and I wrote a little about that in our 2019 paper. We noted first that there are two types of transparency: transparency of outputs-- how did each bank do in the stress scenarios?--and transparency of inputs--what models did the Fed use? For both, our message was that transparency in stress testing, as in banking supervision generally, is a double-edged sword. For outputs, the goal would be to reveal just enough about banks to help market participants evaluate their risks. But not so much as to undermine confidence when it should not be undermined, and especially not to create widespread panic. For inputs, the goal would be to reveal just enough to help banks develop their models and manage their risks, and to inform regulators and markets about bank resiliency. But not so much that stress tests become a predictable "compliance exercise" or become easy to game.
I'll make two observations about those tradeoffs.
First, US supervisors are already revealing a lot about the stress test methodologies to the regulated industry, which may allow banks to merely optimize to the stress test rather than build resiliency. The
Second, look what happened to the failed government-sponsored enterprises,
What happened? In retrospect, the law creating the stress-test mandate had important weaknesses. It codified the inflexibility of the central stress scenario. An analysis by three
"One potential reason for this static approach was that OFHEO was required by law to fully disclose the stress test model and went so far as to publish all stress scenarios, empirical specifications, and parameter estimates in the
Conclusion
In short, supervisory stress tests are very important for bank risk management and supervisory oversight. I'm concerned, as are many others, that the tests have become too routinized and bureaucratized, and that further disclosures from regulators will simply make them more so.
With thanks to outstanding research support from
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Read this original document at: https://docs.house.gov/meetings/BA/BA20/20240626/117459/HHRG-118-BA20-Wstate-FeldbergG-20240626.pdf
"Stress Testing: What's Inside the Black Box?"
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