Stress test

Ten Precepts for 21st Century Regulators

The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one in place 15 years ago. Yet, the events of March 2023 make clear that the progress thus far is simply not enough. To ensure resilience, we need to do more.

To steer the process of further reform, we propose a set of 10 precepts that those who make the rules should keep in mind as they refine the prudential framework. These practical guidelines lead us to conclusions that mirror those in a recent post: regulation should be more rule-based (less reliant on supervisory insight or discretion); simpler and more transparent; stricter and more rigorous; and more efficient in its use of resources. Concretely, this approach means increasing capital and liquidity requirements; shifting to mark-to-market accounting; and improving the transparency, flexibility and severity of capital and liquidity stress tests.

Read More

Making Banking Safe

The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one we had 15 years ago. Today, banks and some nonbanks face more rigorous capital and liquidity requirements. Improved collateral rules for market-making activities can dampen shocks. And, some institutions are subject to well-structured resolution regimes.

Yet, the events of March 2023 make clear that the system remains fragile. The progress thus far is simply not enough. What else needs to be done?

In a new essay, we address this critical question. Our assessment of the banking system turmoil of 2023 leads us to several obvious conclusions, some of which clearly escaped both bank managers and their supervisors. Perhaps the simplest and most significant is that banks can survive either risky assets or volatile funding, but not both. Another is that supervisors are willing to treat some banks as systemic in death, but not in life.

We also draw two compelling lessons from the recent supervisory and resolution debacles. First, a financial system which relies heavily on supervisory discretion is unlikely to prove resilient. Second, authorities with emergency powers to bail out intermediaries during a panic will always do so. That is, policymakers are incapable of making credible commitments to impose losses on depositors and others. In our view, the only way to address this commitment problem is to prevent crises….

Read More

The Extraordinary Failures Exposed by Silicon Valley Bank's Collapse

The collapse of Silicon Valley Bank (SVB) revealed an extraordinary range of astonishing failures. There was the failure of the bank’s executives to manage the maturity and liquidity risks that are basic to the business of banking: they failed Money and Banking 101. There was the failure of market discipline by investors who either didn’t notice or didn’t care about the fact that the bank was severely undercapitalized for the better part of a year before it collapsed. There was the failure of the supervisors to compel the bank to manage the simplest and most obvious risks. And, there was the failure of the resolution authorities to act in mid-2022 when SVB’s true net worth had sunk far below the minimum threshold for “prompt corrective action.”

Waiting several quarters to act deepened the threat to the financial system, undermining confidence not only in many other banks but also in the competence of the supervisors. The extraordinary rescue actions last week by both the deposit insurer (FDIC) and the lender of last resort (Federal Reserve) are just a sign of the high costs associated with restoring financial stability when confidence plunges.

In this post we discuss each of these four failures, as well as the actions that authorities took to stabilize the financial system following the SVB failure. To anticipate our conclusions, we see an urgent need for officials to do at least five things:

  • First, to regain credibility, supervisors need to do an immediate review of the unrealized losses on the balance sheets of all 45 banks with assets in excess of $50 billion.

  • Second, they should perform a speedy and focused stress test on each of these banks to assess the  impact on their true net worth of a sizable further increase in interest rates. Any bank with a capital shortfall should be compelled either to issue new equity or shut down. (To ensure the availability of the necessary resources, authorities will need to have a pool of public funds available to recapitalize banks that cannot attract private investors.)

  • Third, to restore resilience, Congress must reverse the 2018-19 weakening of regulation that allowed medium-size banks to escape rigorous capital and liquidity requirements.

  • Fourth, the authorities must change accounting rules to ensure that reported capital more accurately reflects each bank’s true financial condition.

  • Finally, policymakers should assess the impact on the financial system and on the federal debt arising from the now-implicit promise to insure all deposits in a crisis. To limit risk taking, correspondingly greater fees and higher capital and liquidity requirements should accompany any explicit increase in the cap on deposit insurance.

Read More

Financial System Resilience: The Climate Change Edition

Supervisors around the world wish to ensure that the financial system is resilient to climate change. To that end, current best practice is to formulate detailed long-run climate scenarios and then ask whether financial institutions, especially banks, can withstand the losses associated with them. These scenarios typically map the path of surface temperature, sea level, and the resulting economic damage over the next 30 or 40 or 50 years.

However, financial-system stress arises from sudden, widespread changes in the value and perceived quality of leveraged intermediaries’ assets, while climate change is likely to remain gradual over decades. As a result, skeptics reasonably doubt that climate change poses systemic financial risk sufficient to merit the use of scarce supervisory resources and a costly testing apparatus. To quote John Cochrane: “[B]anks did not fail in 2008 because they bet on radios not TV in the 1920s. Banks failed over mortgage investments they made in 2006.”

Fortunately, we now have low-cost, high frequency, forward-looking tools for monitoring climate-related sources of financial instability. In this post, we use one such tool to identify episodes in which the potential influence of climate change on systemic resilience may be worthy of attention. We also look at how an aggregate measure of financial system vulnerability evolves over time….

Read More

Central Banks' New Frontier: Interventions in Securities Markets

In his 2016 book The End of Alchemy, our friend and former Bank of England Governor Mervyn King provided a template for financial reform aimed at reducing the frequency and severity of crises. At the time, we were very cautious for two reasons. First, we believed that adoption of King’s framework would vastly increase the influence of central banks on private financial markets, something that could ultimately lead to a misallocation of resources in the economy and to a diminution of the independence of monetary policy that is necessary for securing price stability. Second, we doubted that most central banks had the technical capacity to implement the proposal.

Well, the landscape has changed significantly. During the pandemic, central banks intervened massively in private securities markets and there now appears to be no turning back. In a number of jurisdictions, monetary policymakers broadened the scale and scope of their lending and intervened directly in financial markets, going significantly beyond even their extraordinary actions during the 2007-09 financial crisis. As a result, we likely will be paying the costs that we feared could accompany the implementation of King’s proposal, so we might as well reap the benefits.

In this post, we discuss central banks’ pandemic interventions and the type of infrastructure needed to support them. We then review King’s proposal, highlighting how adopting his approach would make the financial system safer, while radically simplifying the role of regulators and supervisors ….

Read More

U.S. Gets a Start on Climate-related Financial Risk

Co-authored with Richard Berner, NYU Stern Clinical Professor of Finance and Co-Director, Volatility and Risk Institute.

Many sources of risk threaten the U.S. financial system. Pandemic risk and cyber risk are at or near the top of our list of nightmares. Yet, with the UN Climate Change conference (COP26) under way in Glasgow, attention is shifting to efforts aimed at limiting the economic and financial damage from climate change, including a timely new “Report on Climate-related Financial Risk” from the U.S. Financial Stability Oversight Council (FSOC).

As the Report makes clear, U.S. policymakers need a far better understanding of climate-related financial risk. Indeed, when President Biden issued an executive order in May instructing financial regulators to conduct a thorough risk assessment, the United States already was behind other advanced economies. As an initial response to the President’s directive, the Report catalogs the range of climate risk threats, describes actions individual U.S. regulators have begun taking to address them, and lists many things that still need to be done. By setting priorities, the FSOC is now putting climate change “squarely at the forefront of the agenda of its member agencies.”

In this post, we highlight three themes in the Report: (1) the ongoing rise of physical climate risk; (2) the conceptual challenges associated with measurement, as well as the data gaps; and (3) the benefits of scenario analysis as a tool for assessing the financial stability risks arising from climate change. The key lesson that we draw from scenario analysis is that a financial system resilient to a range of other shocks is more likely to be resilient against climate risk. Put differently, a less-resilient financial system is vulnerable to all types of shocks, including those arising from climate change.

Read More

Open-end Funds vs. ETFs: Lessons from the COVID Stress Test

COVID-19 posed the most severe stress test for financial markets and institutions since the Great Financial Crisis (GFC) of 2007-09. By some measures, the COVID shock’s peak impact was larger than that of the GFC—both the VIX rose higher and intermediaries’ estimated capital shortfalls were bigger. As a result, the COVID experience provides a natural laboratory for testing the resilience of many parts of the post-GFC financial system.

For example, the March 2020 dysfunction in the corporate bond market highlights the extraordinary fragility of a market that accounts for nearly 60% of the debt and borrowings of the nonfinancial corporate sector. Yield spreads over equivalent Treasuries widened further than at any time since the GFC, with bond prices plunging even for instruments that have little risk of default. (See Liang for an excellent overview.)

In this post, we focus on how, because of the contractual agreement with their shareholders, an extraordinary wave of redemptions created selling pressure on corporate bond mutual funds that almost surely exacerbated the liquidity crisis in the corporate bond market. To foreshadow our conclusions, we urge policymakers to find ways to reduce the gap between the illiquidity of the assets held by corporate bond (and some other) mutual funds and the redemption-on-demand that these funds provide. To reduce systemic fragility, we also urge them—as we did several years ago—to consider encouraging conversion of mutual funds holding illiquid assets into ETFs, which suffered relatively less in the COVID crisis….

Read More

Stress tests lack COVID-scale stress

In recent months, the Federal Reserve acted aggressively to support nearly all parts of the U.S. economy. Unprecedented monetary policy actions, both in size and scope, served to maintain market function and the flow of credit. And, while we have misgivings about the Fed’s CARES Act-driven moves to support the nonfinancial sector, we applaud Chair Powell and his colleagues for their quick and decisive actions (see our previous posts here, here and here). This, together with fiscal policy support for individual households and small firms, has kept an awful situation from becoming far worse—at least for now.

But, the Fed’s responsibility extends beyond monetary policy to the regulatory and supervisory arenas: it is obliged to maintain the safety and soundness of the banking system (and, to some extent, of the broader financial system). On this score, and in stark contrast to its actions in 2009, the Board of Governors has come up significantly short. Without full disclosure of the latest stress test results, suspicions will linger about the ability of the largest banks to provide credit to healthy borrowers if the COVID recovery falters. (See our earlier post for details.)

In this post, we examine the results from the Fed’s 2020 assessment of bank capital adequacy published on June 25. Based on the COVID-related sensitivity analysis—for which individual results are unavailable—one-quarter of the 33 banks tested fall below the regulatory minimum in the worst of the three cases. The fact that we can only guess which banks those might be creates suspicion regarding many banks….

Read More

An Open Letter to Randal K. Quarles, Federal Reserve Vice Chair for Supervision

Dear Vice Chair Quarles,

Nearly three years ago, we wrote an open letter congratulating you on your nomination as the first Vice Chair for Supervision on the Board of Governors of the Federal Reserve System. In that letter, we highlight the central mission of ensuring the resilience and promoting the dynamism of the U.S. financial system.

Today we write to express our profound disappointment regarding the plans (expressed in your June 19 speech on “The Adaptability of Stress Testing“) to limit the disclosure of this year’s large-bank stress tests. In our view, failure to publish the individual bank results from the special COVID-19 related “sensitivity analysis” weakens the credibility and effectiveness of the Fed’s stress testing regime.

Consequently, we urge you to reverse course and to announce this week the individual bank sensitivity results, along with the aggregates. To put it bluntly, the point of a supervisory stress test is disclosure. Anything short of full transparency leaves potentially destabilizing questions unanswered.

Read More

COVID-19 Stress Test

The COVID-19 shock is almost surely leading to a larger economic downturn than the Great Financial Crisis of 2007-09. However valuable, neither stress tests nor financial supervision in general has prepared us for a shock of this magnitude.

These developments leave us profoundly concerned that the global financial system lacks the resilience needed to weather what will clearly be a very violent storm. In our view, the most up-to-date information regarding the impact on the financial system of COVID-19 comes from NYU Stern Volatility Lab’s SRISK. By utilizing timely weekly market equity data, rather than less accurate and substantially delayed book-value information, SRISK enables us to gauge the aggregate shortfall of capital in the financial system during a crisis (defined as a 40 percent drop of the global equity market over the next six months). Analogous to a severe stress test, the idea behind SRISK is that an intermediary contributes to fragility to the extent that it is short of capital at the same time that there is a system-wide shortfall (see, for example, here). Just as a forest is more vulnerable to fire during a drought, so the financial system is more vulnerable to a large shock when there is a large aggregate capital shortfall.

In the remainder of this post, we highlight some recent SRISK developments and compare them to those during the 2007-09 crisis. We view these developments as a clear warning to regulators and supervisors that the COVID-19 shock meaningfully threatens financial stability across major jurisdictions….

Read More

Contagion: Bank Runs and COVID-19

There are currently more than 85,000 confirmed cases of COVID-19 in at least 60 countries. Yet, we know very little about this pathogen, except that everyone is worried. And, with the number of cases rising each day, intensifying concerns probably will lead many people to behave in ways that undermine economic activity. They will shy away from places where the virus can be transmitted. That means avoiding mass transit, schools, and workplaces.

Moreover, many people will stay away until they are confident that the disease is manageable. That confidence probably requires an effective treatment, a very low likelihood of infection, or both. Not surprisingly, many observers are reducing their projections for economic growth this year, while financial market participants anticipate easier monetary policy to cushion the shock.

The challenge of re-establishing public confidence that it is safe to venture out bears striking similarity to the one that authorities face in stemming a bank run. Our ability to identify and quarantine people infected with COVID-19 is analogous to our ability to recognize and isolate a bank bordering on insolvency. This and other similarities suggest that the means we use to control bank runs also may be useful in managing the economic consequences of an emerging pandemic like COVID-19….

Read More

Stress Testing Financial Networks: The Case of CCPs

Following the crisis of 2007-09, in which AIG’s bilateral derivatives trades played a notable role, the G20 leaders called for central clearing of standardized derivatives. The resulting shift has been dramatic: central counterparties (CCPs) now clear about three-fourths of interest rate contracts, up from less than one-fourth a decade earlier (see Faruqui, Huang and Takáts).

By substituting a CCP as the buyer to every seller and the seller to every buyer, central clearing mutualizes and can—with appropriate margining, trade compression, position liquidation procedures, and reporting—reduce counterparty risk (see Tuckman). CCPs also contribute to financial resilience by promoting uniform margin standards, reducing collateral and liquidity needs, and making risk concentrations (like that of AIG in the run-up to the crisis) more transparent.

At the same time, the shift to central clearing has concentrated risk in the CCPs themselves. Reflecting economies of scale and scope, as well as network externalities, a few CCPs serving global clearing needs have grown enormous. For example, as of the last report at end-September 2018, open interest at LCH Clearnet exceeded $250 trillion. Moreover, the clearing activity of some CCPs lacks any short-run substitute. As a result, to avoid disrupting large swathes of the global financial system, any recovery or resolution plan for these CCPs must ensure continuity of service (see CCP Resolution Working Group presentation to the OFR Financial Research Advisory Committee). Finally, CCPs are the most interconnected intermediaries on the planet, making them channels for transmission and amplification of financial distress within and across jurisdictions. As then-Governor Powell clearly states in the opening quote, the safety of CCPs is central to the resilience of the global financial system.

We and Richard Berner have been studying how regulators use stress tests (see our earlier posts here and here) to assess the resilience of financial networks, including banks and nonbanks. In our joint work, we focus on CCPs due to their centrality, their extreme interconnectedness and their lack of substitutability. This post is based on our research….

Read More

Assessing Housing Risk

Housing debt typically is on the short list of key sources of risk in modern financial systems and economies. The reasons are simple: there is plenty of it; it often sits on the balance sheets of leveraged intermediaries, creating a large common exposure; as collateralized debt, its value is sensitive to the fluctuations of housing prices (which are volatile and correlated with the business cycle), resulting in a large undiversifiable risk; and, changes in housing leverage (based on market value) influence the economy through their impact on both household spending and the financial system (see, for example, Mian and Sufi).

In this post, we discuss ways to assess housing risk—that is, the risk that house price declines could result (as they did in the financial crisis) in negative equity for many homeowners. Absent an income shock—say, from illness or job loss—negative equity need not lead to delinquency (let alone default), but it sharply raises that likelihood at the same time that it can depress spending. As it turns out, housing leverage by itself is not a terribly useful leading indicator: it can appear low merely because housing prices are unsustainably high, or high because housing prices are temporarily low. That alone provides a powerful argument for regular stress-testing of housing leverage. And, because housing markets tend to be highly localized—with substantial geographic differences in both the level and the volatility of prices—it is essential that testing be at the local level….

Read More

FEMA for Finance

Modern financial systems are inherently vulnerable. The conversion of savings into investment—a basic function of finance—involves substantial risk. Creditors often demand liquid, short-term, low-risk assets; and borrowers typically wish to finance projects that take time to generate their uncertain returns. Intermediaries that bridge this gap—transforming liquidity, maturity and credit between their assets and liabilities—are subject to runs should risk-averse savers come to doubt the market value of their assets.

The modern financial system is vulnerable in a myriad of other ways as well. For example, if hackers were to suddenly render a key identification technology untrustworthy, it could disable the payments system, bringing a broad swath of economic activity to an abrupt halt. Similarly, the financial infrastructure that implements most transactions—ranging from retail payments to the clearing and settlement of securities and derivatives trades—typically relies on a few enormous hubs that are irreplaceable in the short run. Economies of scale and scope mean that such financial market utilities (FMUs) make transactions cheap, but they also concentrate risk: even their temporary disruption could be catastrophic. (One of our worst nightmares is a cyber-attack that disables the computer and power grid on which our financial system and economy are built.)

With these concerns in mind, we welcome our friend Kathryn Judge’s innovative proposal for a financial “Guarantor of Last Resort”—or emergency guarantee authority (EGA)—as a mechanism for containing financial crises. In this post, we discuss the promise and the pitfalls of Judge’s proposal. Our conclusion is that an EGA would be an excellent tool for managing the fallout from dire threats originating outside the financial system—cyber-terrorism or outright war come to mind. In such circumstances, we see an EGA as a complement to existing conventional efforts at enhancing financial system resilience.

However, the potential for the industry to game an EGA, as well as the very real possibility that politicians will see it as a substitute for rigorous capital and liquidity requirements, make us cautious about its broader applicability. At least initially, this leads us to conclude that the bar for invoking an EGA should be set very high—higher than Judge suggests….

Read More

Financial Crisis: The Endgame

Ten years ago this month, the run on Lehman Brothers kicked off the third and final phase of the Great Financial Crisis (GFC) of 2007-2009. In two earlier posts (here and here), we describe the prior phases of the crisis. The first began on August 9, 2007, when BNP Paribas suspended redemptions from three mutual funds invested in U.S. subprime debt, kicking off a global scramble for safe, liquid assets. And the second started seven months later when, in response to the March 2008 run on Bear Stearns, the Fed provided liquidity directly to nonbanks for the first time since the Great Depression, completing its crisis-driven evolution into an effective lender of last resort to solvent, but illiquid intermediaries.

The most intense period of the crisis began with the failure of Lehman Brothers on September 15, 2008. Credit dried up; not just uncollateralized lending, but short-term lending backed by investment-grade collateral as well. In mid-September, measures of financial stress spiked far above levels seen before or since (see here and here). And, the spillover to the real economy was rapid and dramatic, with the U.S. economy plunging that autumn at the fastest pace since quarterly reporting began in 1947.

In our view, three, interrelated policy responses proved critical in arresting the crisis and promoting recovery. First was the Fed’s aggressive monetary stimulus: after Lehman, within its mandate, the Fed did “whatever it took” to end the crisis. Second was the use of taxpayer resources—authorized by Congress—to recapitalize the U.S. financial system. And third, was the exceptional disclosure mechanism introduced by the Federal Reserve in early 2009—the first round of macroprudential stress tests known as the Supervisory Capital Assessment Program (SCAP)—that neutralized the worst fears about U.S. banks.

In this post, we begin with a bit of background, highlighting the aggregate capital shortfall of the U.S. financial system as the source of the crisis. We then turn to the policy response. Because we have discussed unconventional monetary policy in some detail in previous posts (here and here), our focus here is on the stress tests (combined with recapitalization) as a central means for restoring confidence in the financial system….

Read More

Bank Capital and Stress Tests: The Foundation of a Thriving Economy

We submitted this statement to the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Financial Services of the U.S. House of Representatives for its hearing on July 17, 2018.

We appreciate the opportunity to submit the following statement on the occasion of the hearing entitled “Examining Capital Regimes for Financial Institutions.” We welcome the Subcommittee’s further examination of the existing regulatory approach for prudentially regulated financial institutions.

We are academic experts in financial regulation with extensive knowledge of the financial industry. Our experience includes working with private sector financial institutions, government agencies and international organizations. In our view, a strong and resilient financial system is an essential foundation of a thriving economy. The welfare of every modern society depends on it. The bedrock of this foundation is that banks’ capital buffers are sufficient to withstand significant stress without recourse to public funds. Furthermore, it is our considered view that the benefits of raising U.S. capital requirements from their current modest levels clearly outweigh the costs.

To explain this conclusion, we start with a definition of bank capital, including a discussion of its importance as a mechanism for self-insurance. We then turn to capital regulation and a discussion of stress testing….

Read More

Size is Overrated

This month, in the guise of supporting community banks, the U.S. Senate passed a bill (S.2155) that eases regulation of large banks. We share the critics’ views that this wide-ranging dilution of existing regulation will reduce the resilience of the U.S. financial system.

In its best known and most publicized feature, the Senate bill raises the asset size threshold that Dodd-Frank established for subjecting a bank to strict scrutiny (such as the imposition of stress tests, liquidity requirements, and resolution plans) from $50 billion to $250 billion. In this post, we examine the role of asset size in determining the systemic importance of a financial intermediary. It turns out that (aside from the very largest institutions, where it does in fact dominate) balance sheet size is not a terribly useful indicator of the vulnerability a bank creates. We conclude that Congress should ease the strict oversight burden on institutions that pose little threat to the financial system without raising the Dodd-Frank threshold dramatically.

Judge makes an elegant proposal for accomplishing this. For institutions with assets between $100 billion and $250 billion, Congress should just flip the default. Rather than obliging the Fed to prove a mid-sized bank’s riskiness, give the bank the opportunity to prove it is safe. This approach gives institutions the incentive to limit the systemic risk they create in ways that they can verify. It also sharply reduces the risk of litigation by banks that the Fed deems risky...

Read More

Time Consistency: A Primer

The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.

For simplicity, we will define a time consistent policy as one where a future policymaker lacks the opportunity or the incentive to renege. Conversely, a policy lacks time consistency when a future policymaker has both the means and the motivation to break the commitment.

In this post, we describe the conceptual origins of time consistency. To emphasize its broad importance, we provide three economic examples—in monetary policy, prudential regulation, and tax policy—where the impact of the idea is especially notable....

Read More

Ensuring Stress Tests Remain Effective

Last month, the Federal Reserve Board published proposed refinements to its annual Comprehensive Capital Analysis and Review (CCAR) exercise—the supervisory stress test that evaluates the capital adequacy of the largest U.S. banks (34 in the 2017 test). In our view, the Federal Reserve has an effective framework for carrying out these all-important stress tests. Having started in 2011, the Fed is now embarking on only the seventh CCAR exercise. That means that everyone is still learning how to best structure and execute the tests. The December proposals are clearly in this spirit.

With this same goal in mind, we make the following proposals for enhancing the stress tests and preserving their effectiveness:

---  Change the scenarios more aggressively and unexpectedly, continuing to disclose them only after banks’ exposures are fixed.
---  Introduce an experimental scenario (that will not be used in “grading” the bank’s relative performance or capital plans) to assess the implications of events outside of historical experience and to probe for weaknesses in the system.
---  As a way to evaluate banks’ internal models, require publication of loss rates or risk-weighted assets for the same hypothetical portfolios for which the Fed is disclosing its estimates.
---  Stick with the annual CCAR cycle....

Read More

Basel's Refined Capital Requirements

After nearly a decade of negotiations, last month, the Basel Committee on Banking Supervision completed the Basel III post-crisis reforms to capital regulation. The final standards include refinements to: credit risk measurement and the computation of risk-weighted assets; the calculation of off-balance-sheet exposures and of the requirements to address operational risk; and the leverage ratio requirement for global systemically important banks (G-SIBs).

In this post, we focus on revisions to the way in which banks compute risk-weighted assets. To foreshadow our conclusion: the new approach adds unnecessarily to regulatory complexity. If the concern is that current risk-based requirements result in insufficient capital, it would be better simply to raise the requirements.

Read More
Mastodon