What is stress testing?
Stress testing is a form of assessment used to determine if
financial institutions have the necessary capital requirements
to withstand the effects of various potentially damaging
economic scenarios. Bank capital is defined as its net cash,
loans and securities.
Banks, and other financial companies, look at their balance
sheets and simulate a number of economic events, taking into
account what has already happened, what kinds of things will
happen to their portfolios if adverse events occur, and
whether they have robust enough capital levels to cope with
Why is it necessary in the United
It is widely accepted that the 2008 financial crisis came as
a result of a liquidity shortage caused by over lending in the
US home mortgage securities sector. Banks offered mortgages and
loans to borrowers who could not afford the repayments,
eventually leading to a default that had disastrous effects on
In 2010, two years later, the Obama administration passed the
Dodd–Frank Wall Street Reform and Consumer
Protection Act, passing control of the financial system to
the government, and introducing several provisions designed
to prevent future risk. In an attempt to prevent a repeat of
the very circumstances that led to the crisis in the first
place, Dodd-Frank introduced provisions for bank stress
testing to monitor banks capital levels.
Section 165(i) of the Act provides that the appropriate
primary financial regulatory agencies, and the Federal
Insurance Office have to conduct annual stress testing on
non-bank and banking financial institutions to evaluate if they
'have the capital, on a total consolidated basis, necessary to
absorb losses as a result of adverse economic
Although important, mortgages are only one piece of the
puzzle. Stress testing looks at a set of assumptions across
many additional sectors including the labour and the capital
markets. These markets become constrained within certain
parameters, and if an adverse event happens, there is a need
to evaluate what happens to losses and what effect this has
on the institution’s portfolio.
Who has to undergo stress testing in the
In the US banking system there are two types of stress
testing that institutions have to perform, to prove that they
can handle the duress that any situation may throw their
Under the supervision of the Federal Reserve Board of
Governers, the comprehensive capital analysis and review (CCAR)
complements Dodd-Frank stress testing. It is however separate
as they are run in coordination to avoid repetition. It looks
at an institution’s 'capital adequacy, internal
capital adequacy assessment processes, and their individual
plans to make capital distributions, such as dividend payments
or stock repurchases’.
The Fed administers a number of forward looking tests to
bank holding companies (BHCs), US intermediate holding
companies (IHCs), savings and loan holding companies, state
member banks, and non-bank financial institutions, as
determined by the Financial Stability Oversight Council (FSOC).
CCAR is limited to financial institutions with $50 billion or
more of consolidated asserts, of which there are currently 34.
According to the Fed:
'[Its] expectations for capital planning practices are
tailored to the size, scope of operations, activities, and
systemic importance of a particular
The second type of stress test is run bi-annually by
financial institutions that hold total assets of $10 billion or
more, using similar methodology but under strict reporting
rules. The institutions must publish the results of these
stress tests on a specific date based on their assets, and they
are available to the public.
What are the scenarios of a stress
The scenarios that these institutions are tested on are
baseline - the actual situation or status quo - a situation
used in the beginning of all exercises, as well as adverse and
severely adverse scenarios that imply a different level of
These scenarios include
several economic variable possibilities; macroeconomic
activity such as inflation, unemployment, gross
domestic product, exchange rates, income deviation and
These scenarios include several economic variable
possibilities; macroeconomic activity such as inflation,
unemployment, gross domestic product, exchange rates, income
deviation and interest rates. The latter of the three are
purely hypothetical situations.
So why is this up for debate?
The stress testing process gives an improved picture of the
capital that the banking institution has and how much capital
it is going to have in times of stress. However, because
it’s based on a set of increasingly hypothetical
variables, while it may paint a positive picture, how good that
picture is is or how accurate it is entirely open to debate.
Outcomes will be different if the assumption is that house
prices are going to go down by five, 10 or even 40%.
"You have to realise you are making a lot of assumptions that
may or may not be warranted, and may be debatable," said
Oliver Ireland, partner at Morrison & Foerster. "The
numbers that are being used to do that stress testing can be
exaggerated numbers, or simply the wrong ones. Some of them
are better than they should be, some of them are worse than
they should be."
There is a sense that there is a false precision to those
stress tests and some of the assumptions that are the basis of
them aren’t warranted, he said.
Other adversaries to the process suggest that stress testing
has become laborious, overly time consuming and expensive. The
process of bank stress testing has become overly complex, and
no longer achieves the intention it was originally designed to
What does the current administration think of stress
President Trump is a vocal adversary of Dodd-Frank and much
of what it stands for, including stress testing. Less than two
weeks after his inauguration he released an executive order
calling on the Secretary of the Treasury, Steven Mnuchin, to
report on whether all key US rules and regulations inhibit the
progression of the US economy, and laid out his Core Principles
by which the financial system shall henceforth be governed.
In response to this, Mnuchin released in June his report to
Trump looking at the banking sector, A Financial System That
Creates Economic Opportunities. In this the Treasury suggested
a number of recommendations allowing for tailoring of the
stress testing parameters. The provisions are 'aimed at both
decreasing the burden of statutory stress testing and improving
its effectiveness by tailoring the stress-testing requirements
based on the size and complexity of
For company led testing, for example, it recommends raising
the participation threshold from $10 billion to $50 billion,
and allowing the regulators flexibility to tailor thresholds
depending on circumstances, so that those with greater balance
sheets may also be exempt in certain situations –
business model, balance sheet, and complexity.
The Treasury also recommended removing the mid-year stress
test cycle and the adverse testing scenario, and allowing
banks to make their own determinations for the FED led
CCAR, it also suggested, is too subjective and should not be
used as an objection to a financial institutions capital
So where are we now?
Not long after this report was released, all 34 of the
US’s biggest banks passed the stress tests for the
first time ever, meaning they all hold enough capital according
to its stipulations. Capital One Financial was asked to address
certain weaknesses in its capital plan, and has six months to
Banks can raise capital, and arguably reduce their potential
for failure due to loan losses, but in doing so are also
raising the cost of borrowing in the economy, said Ireland. Fed
policy since 2008 has encouraged borrowing by maintaining low
interest rates, but at the same time has a bank capital policy
that discourages lending.
"Are the numbers too high?" said Ireland. "If everybody
passes the stress test, well that is wonderful, but if the
interest rates are too high, then it is having other effects
on the economy."
It is likely that if the current Administration remains in
place for the foreseeable future, stress testing will be
radically changed to allow banks to take greater risks, whether
this is sensible or not is a question of politics, not
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