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. The tactical area is research that helps improve supervisory models. First, developing additional ways of projecting revenues and non-credit expenses in stressed environments is a particularly ripe area for additional work, in my view. As I noted, an important innovation in the SCAP was the recognition that a comprehensive stress test focused on net income needed to incorporate projections of interest and non-interest income and non-interest expense. While a number of models already existed for making such projections – for instance, those used by banks in their budgeting and planning processes – these were nearly all calibrated to produce projections assuming business as usual conditions, rather than the stressed environment assumed in the SCAP. The SCAP PPNR projections were thus based on stylized supervisory models that used available historical data on bank performance during recessions. Since then, the supervisory PPNR models have become considerably more sophisticated, but at their heart, they continue to rely on historical outcomes for revenues and expenses, rather than fully incorporating the fundamental drivers of those outcomes at the business line level. Additional research and data 5/8  BIS central bankers' speeches  collection on these fundamental drivers and their performance under stress could make the PPNR projections more robust to changing business strategies and focus. A second tactical research area concerns measuring model risk.

The DFAST and CCAR stress tests adopt a “walk-through-time” approach, in which net income and capital ratios are calculated on a quarterby-quarter basis throughout the stress test horizon.10 An alternative approach would be to apply cumulative losses and revenues in a single, instantaneous shock – this was what was done in the SCAP. While the two approaches might be assumed to produce roughly consistent results, the walk-through-time approach may better capture true vulnerabilities, especially in cases where negative net income quarters come early in the stress test horizon but revenues accrue most strongly in subsequent quarters. The instantaneous shock approach implicitly recognizes revenues from later in the horizon as offsets to losses that occur early in the horizon and thus may overstate true capital resources. The tradeoff is that the walk-through-time approach implies a degree of precision about the quarter-by-quarter pattern of losses and revenues that might be beyond the capabilities of existing modeling technology (this was the judgment at the time of the SCAP). But the walk-through-time approach requires further assumptions, particularly regarding the evolution of the balance sheet. These assumptions range from how to capture maturing loans and securities; what to assume about prepayments; what new lending occurs over the horizon (including replacement of maturing or prepaid positions); and whether to assume that the bank is actively managing its exposures by additional hedging, changes in the credit composition of its portfolios, or restriction of credit supply.