Randal K Quarles: Themistocles and the mathematicians - the role
of stress testing
Speech by Mr Randal K Quarles, Vice Chairman for Supervision of the Board of Governors of the
Federal Reserve System, at the Federal Reserve Bank of Atlanta, Atlanta, Georgia (via webcast),
25 February 2021.
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One of the principal themes of human history-and certainly of economic history-is that of a
sudden technological breakthrough originally deployed for one purpose being gradually refined
over time until new and better versions of it are eventually deployed for a much broader range of
purposes. The breakthrough supplies the drama, but it's the steady incremental improvement
over time that makes the greatest difference. The Phoenicians dramatically improved the speed
and cargo load of their commercial voyages with the invention of the trireme-massive boats,
powered with three tiers of oarsmen, rather than the standard one or two-dispatched from Tyre
and Sidon in the service of exploration, commerce, and colonization. But the Greeks improved on
the design, bit by bit, and over many years, until they became not commercial vessels ferrying
cargo from Carthage to Cádiz, but warships that revolutionized naval combat and enabled
Athens-led by the obstinate upstart Themistocles who built a fleet of 200 triremes, the largest
navy Greece had ever seen-to challenge and defeat the Persian King. Or, somewhat closer to
home, consider the development of radar in World War II. That initial innovation was instrumental
in winning the war but continued refinement has led to technologies that can promptly warn us of
tornados or even steer our cars.
In the world of bank supervision, our equivalent of the trireme has been the stress test. The initial
innovation of stress testing gave us an urgently needed tool to measure how much additional
capital banks with mounting losses needed to survive the financial crisis more than a decade
ago. But because we continued with the refinement, we now have a tool that also helps us to set
capital requirements credibly in the banking system, in good times as well as times of financial
stress.
Today, I'd like to share with you my perspective about how stress testing has enhanced the
credibility of our capital adequacy framework, highlight some features of the upcoming stress
test, and offer some thoughts on the importance of continued innovation in supervision. In
particular, I will discuss how stress testing serves as both a general tool to set bank capital
requirements throughout the credit cycle and recently as a specialized tool to provide an
analytical grounding for the decisions we have made on capital distributions during the COVID
event. Then I will briefly review the recently released scenario for the 2021 test and discuss other
changes for the upcoming stress testing cycle.
The 2020 Stress Tests
We now use stress testing in two important but different ways: to set capital requirements during
normal times and to assess capital adequacy during exigent times. In March of last year, the
Board of Governors finalized the stress capital buffer requirement, which uses the Fed's stress
test results to set capital requirements for large banks, and by doing so, simplified our overall
capital regime.
While this new framework has the same goal as the previous Comprehensive Capital Analysis
and Review (CCAR) framework-using forward-looking analysis to help ensure that banks have
sufficient capital to survive a severe recession while still being able to lend to businesses and
household-it integrates our stress testing regime with our ongoing capital requirements so that
large banks now have a single suite of dynamic and risk-sensitive capital requirements. While
that framework is simpler, it is no less stringent than the CCAR framework-a framework that
contributed to a more than doubling of the common equity ratio at banks between 2009 and 2019.
At the time we made the stress capital buffer final last March, we estimated that the stress
capital buffer would have further increased capital requirements for the largest and most
complex banks. By design, the new framework better captures systemic risk by requiring those
banks to establish a buffer to absorb losses they'd take in a severe recession in addition to their
G-SIB surcharges.
It is useful here to pause and put stress testing in the context of bank supervision in general. Both
supervision and stress testing specifically have roles during normal times as well as times of
stress, but those roles are somewhat different depending on the circumstances. Like all
supervision, stress testing conducted during normal times of solid economic growth and financial
stability is aimed at helping ensure banks remain in safe and sound condition. We use it to set
the capital buffers, which give firms incentives to hold capital during normal times, so they are
prepared to weather downturns. During periods of economic and financial turmoil, the goals shift
to understanding banks' exposure to the turmoil and to ensuring that banks can support
households and businesses by continuing to lend. The modern bank stress testing regime was
born in the solvency crisis of 2009 but remains a flexible tool that can be used to understand the
implications of a range of macroeconomic and financial conditions.
That includes conditions that few could have imagined, such as those that descended last
spring. The temporary shutdown of large segments of the economy caused an unprecedentedly
large and swift drop in economic activity. Equally unprecedented was the degree of uncertainty,
both downside and upside, about how the economy would progress throughout the remainder of
2020.
We responded to that abrupt change in environment by adapting stress testing to conduct a
sensitivity analysis, an application of the stress testing models used to inform the Board of
Governors about risks to bank solvency during those rapidly changing conditions. The sensitivity
analysis we conducted was possible because we routinely collect standardized data from banks
on their exposures and have developed our own loss and income models at the Fed. Thus, we
were able to conduct this analysis purely internally, without putting additional burdens on banks
during an already-difficult time. That analysis used the same models as the regular stress test,
but we made several changes with the goal of gaining a real-time understanding of the
implications for bank capital of quite plausible downside scenarios. The sensitivity analysis
included three additional scenarios that reflected the potential economic implications of the
COVID event, as we understood them at the time. We also incorporated targeted adjustments to
account for material changes to bank balance sheets resulting from the COVID event, such as
large drawdowns on corporate credit lines.
At that time of great uncertainty, this sensitivity analysis helped sharpen our understanding of
how banks might fare under the wide range of possible paths of the economy. We published that
analysis to bolster public confidence in the financial system by providing a rigorous and timely
assessment of the condition and prospects for the banking sector, based on data and
wellestablished analytical methods. The additional analysis gave the public a view into the intellectual
underpinnings of the policy actions the Board took, which included special limitations on-but not
a complete elimination of-capital distributions and a requirement for all firms to re-assess their
capital needs and submit another capital plan in late 2020 in light of the economic uncertainty.
The December round of stress tests that followed informed an adjustment to and extension of
the distribution limitations into the first quarter of 2021, and we are continuing to use insights from
the stress tests as we consider when to lift the limitations.
Throughout the COVID event, the stress test has provided analysis necessary to tailor our
actions to the risks we faced, and we have used the results from it to provide the public with
transparency into the analysis that informs our decisions. The investment we've made in the
Fed's own stress test models gave us an extra tool relative to regulators in other jurisdictions,
who generally rely on banks' own models for projections of losses and revenues in their
supervisory stress tests. While those other jurisdictions cancelled or postponed their scheduled
stress tests to avoid putting additional burdens on banks to run models during a period of
financial stress, we expanded our internally-run analysis to meet the evolving conditions. We
used the opportunity to inform ourselves about the impact of various plausible paths that the
recovery might take and to provide the public with more frequent assessments of bank health.
And as a result of the measures taken by the Board and the banks, U.S. bank capital levels
actually increased last year, despite substantial increases in loan loss reserves-funds that
banks set aside to cover expected losses. The aggregate common equity ratio across large
banks increased from 12 percent at the end of 2019 to 12.8 percent at the end of 2020. During
this same time, large banks built roughly $90 billion in loan loss reserves.
It may not have been possible to use stress testing in such a central way had we not done the
work to establish its credibility over the past decade. That credibility is built on a foundation of
cutting-edge models, which estimate how different bank assets would respond to economic
stresses. Our careful execution of those models allows us to confidently disclose detailed results
to the public. Those innovations prepared us to adapt quickly and respond to the unprecedented
shock associated with the COVID event, which confirmed that stress testing is still effective in
these unprecedented times.
The Fed's stress testing models are subject to continual development by experts in credit risk
measurement, borrower behavior, and financial markets. Like a barometer, the models give us
an early warning of stormy financial conditions ahead by distilling bank positions and scenarios
into estimates of potential losses and revenues. These models are reviewed by a group of
experts inside the Fed but outside the stress testing process that challenges their assumptions,
further improving their credibility. The models span all material exposures held by banks,
providing a comprehensive assessment of the risks different types of scenarios pose to overall
bank capital.
Our disclosures of the results stemming from those models, along with transparency about the
model assumptions, have given banks, markets, and the broader public a lens through which to
understand risk in the system. We have built credibility over time through our consistent and
increasingly detailed public disclosures. For nearly a decade, we have published the scenarios
and results, and a few years ago we greatly expanded our disclosure of the modeling
methodology in an additional annual publication.
Looking Ahead to the 2021 Stress Test
Continuing in that tradition, two weeks ago we initiated the 2021 stress test with the publication of
this cycle's stress scenarios. As we've said many times, the scenarios are not projections or
predictions. They are designed according to a longstanding framework that we published after
incorporating feedback from the public. This year, the macroeconomic scenario envisions a
severe global recession accompanied by a period of heightened stress in U.S. commercial real
estate and corporate debt markets. As discussed in recent financial stability reports, the current
environment presents unique challenges for those asset classes, and our focus on them in the
scenarios is consistent with the salient risks they pose to banks. The scenario layers additional
significant stress on top of the stress already absorbed by banks over the past year, with the
unemployment rate rising back to nearly 11 percent and stock prices falling more than 50
percent.
In March, we will publish the details of the methodologies that underlie our models. This will mark
the third year since we enhanced the disclosures to provide significantly more information about
the stress testing models relative to earlier years. That information includes ranges of loss rates,
estimated by using the models, for actual loans held by CCAR firms; portfolios of hypothetical
loans with loss rates estimated by the models; and more detailed descriptions of the models,
such as equations and key variables that influence the results of the models. These disclosures
enhance the ability of the public to understand and interpret the supervisory stress test results.
And as I've noted before, I believe these enhanced disclosures have been a step in the right
direction toward striking the right balance between rigor and transparency. They do not reveal
everything about our models-lest we find ourselves in a "model monoculture" where
supervisors and banks converge on the same sets of risks, ignoring other potential problems.
In June we'll publish the firm-level results from the test. Though 2021 is a year in which smaller
firms are not subject to the supervisory stress test, the Board recently made final a rule that will
allow them to opt in. Should they do so, their results will also be disclosed, and their stress
capital buffers will be updated using the stress test results we publish in June. These actions,
including greater transparency around our stress testing models and greater flexibility in our
stress testing process for smaller firms, represent innovations that I believe help to improve the
effectiveness and efficiency of supervision.
Future Innovation in Stress Testing
As we look to the future, the Fed must continue to innovate so that stress testing remains
effective. In the near term, we must strive to understand the implications of the COVID event on
how we measure financial risk. Borrowers are facing unemployment, cash flow disruptions, and
continued economic uncertainty. The programs put in place to help those borrowers are critical
for our recovery but will further complicate risk modeling as borrower stress may be obscured by
temporary stimulus. For example, it is difficult to tell whether a borrower who has continued to
make loan payments during the COVID event is able to do so because of stimulus payments or
because they have continued to earn income. Borrowers benefitting from temporary forbearance
may or may not be able to resume payments once the forbearance ends.
Over the longer term, we must continue to sharpen our thinking around the interrelationships
between bank risk and broader changes, such as advancing technologies and growth in
nonbank finance. Those forces are undoubtedly altering bank risk, and it will take creative and timely
research to understand the implications. Our agenda also includes initiatives that could reduce
the volatility in the stress test results without sacrificing either their probative value or their rigor.
We will continue to explore those possibilities.
At the same time, we regularly get calls from the public to review various aspects of our models.
For example, in recent years, representatives from an affordable housing group noted that the
global market shock for real estate investments also affected certain lower-risk public welfare
investments, thereby discouraging investment in affordable housing. We deliberatively studied
the issue, concluded that the public welfare investments indeed posed a lower risk to bank
capital than the other real estate investments, and adjusted downward the shock we apply to
those investments in advance of the 2020 stress test.
More recently, we received feedback from banks via appeals of their stress capital buffers. I was
encouraged by the fact that a number of the issues the banks raised were already on our
research agenda. The banks, however, did raise issues relating to interest rate hedges,
losssharing agreements, and loans that use fair value option accounting that the Board directed staff
to investigate and address promptly. I am hopeful that the feedback we receive from the public as
well as our own analysis will help us set the right priorities in our research and development
work.
But innovation is not just about improving tools like stress testing. It is also about identifying new
ways to apply those tools to a broader set of problems faced by the Board, in supervision, and
perhaps beyond. The sensitivity analysis I described earlier demonstrates how we are able to
adapt and apply a familiar tool in a new way to conduct critical analysis at a critical moment.
Drawing on that experience, I believe there is a need for more data and data-driven analysis
broadly in supervision, which is related to the larger goal of enhanced transparency. Important
aspects of supervision are appropriately private, to protect a bank's confidential business
information and to avert speculation about a bank's finances that could be destabilizing. And not
every aspect of a supervisor's work can be quantified. But I believe that there is room for
supervisors to be more transparent about their analytical processes in general, and more
forthcoming about the data used as the basis for supervisory judgments. Stress testing can
serve as an example of what may be possible as we explore those avenues. Themistocles saw
the possibilities of an evolving technology in a changing world. That applies, too, to the ongoing
work of reviewing, adjusting and improving supervision and stress testing to ensure that banks
can continue supporting households and businesses in good times and in those that are more
challenging.