The Federal Reserve’s stress testing exercise has evolved considerably over the past fifteen years. There is always some twist or turn keeping banks on their toes – and CCAR 2024 is no exception.
The Supervisory Capital Assessment Program (SCAP) tested the largest US banks’ capital adequacy during the 2008/2009 financial crisis, and as such was the initial foray into stress testing as a primary determinant of large bank capital planning. SCAP’s success led the Federal Reserve (FRB) to introduce the Comprehensive Capital Analysis and Review (CCAR), which codified stress testing into capital planning. Over time, CCAR has expanded the number of participating firms, introduced new scenario components, and significantly raised supervisory expectations for large bank capital planning and stress testing processes.
Many firms struggled to keep pace with evolving supervisory expectations. From 2013-2018, the FRB objected to or required a firm to resubmit its capital plan on more than 15 occasions and provided substantive supervisory feedback to all CCAR participants. Banks in turn invested significantly in people, processes, modeling capabilities, and technology, while significantly building up capital. As the CCAR program matured, the FRB embedded its qualitative capital plan assessments into its regular supervisory processes.
Just when it seemed that CCAR would become routine, 2020 brought significant change. The FRB introduced the Stress Capital Buffer (SCB), explicitly incorporating stress testing into minimum capital requirements. Changes were also made to comply with the ‘tailoring rule’, including removing the supervisory ‘adverse’ scenario and relaxing the testing frequency for Category III and IV firms. Covid brought economic activity to a halt, plunging the US into a deep recession. The FRB conducted a second round of stress testing in fall 2020, forcing firms to figure out how to adapt scenario design and stress testing models to conduct stress testing while in the middle of a severe economic downturn.
The US economy quickly recovered and stress testing processes once again returned to ‘steady state’. However, issues with persistent inflation caused the FRB to initiate a rate hiking cycle in March 2022, exposing poor interest rate risk and liquidity management practices among some firms. To test the impact of higher rates on the US Global Systemically Important Banks (G-SIBs), the FRB introduced an exploratory market shock in CCAR 2023.1
Prompted by last year’s bank failures, the FRB is now expanding CCAR by introducing multiple, exploratory scenarios as a companion exercise to the primary test.2 As Federal Reserve Vice Chair for Supervision Michael Barr noted in October 2023, these additional scenarios are intended to reflect a “wide range of outcomes for the banking system”.3 The exploratory scenarios will not directly affect capital requirements (i.e. will not set the stress capital buffer), but they will serve to identify potential underlying weaknesses and bank specific or industry wide supervisory focal points.
The FRB’s review of the Silicon Valley Bank failure issued in April 2023 noted that the use of multiple scenarios in stress testing was already “in progress”.4 Accordingly, the industry has been preparing for this change for some time, despite not knowing the precise nature of the new scenarios.
Vice Chair Barr laid out the rationale for multiple scenarios in his October 2023 address, highlighting three specific limitations of the current single scenario approach. Barr’s concerns included:
1) Constraints on Scenario Design
A single recessionary scenario and market shock, by definition, cannot cover the range of plausible risks faced by all large banks. The FRB is bound by rule to design a scenario that meets certain conditions (e.g. steep decline in house prices) that, for congruency reasons, limits its ability to design severe, but plausible scenarios. In addition, the scenarios do not contain explicitly contain second-order effects, which Barr notes could amplify the shocks’ effects and potentially lead to losses spreading further.
2) Behavioral Incentives for Banks
Scenarios that test for the same underlying risks each year could disincentivize firms from investing in their own risk management. Due to this iteration of risk factors, testing can become predictable and possibly even encourage risk concentrations in assets that receive comparably favorable capital treatment. As a result, scenarios need to evolve to reduce the possibility of unintended consequences.
3) Model Limitations
Stress testing models are generally trained on historical data and therefore may not be responsive to structural breaks, such as a once-in-a-lifetime global pandemic, or important changes in technology. Exploratory scenarios allow the FRB to have more flexibility in its modeling approaches given that a broader range of risk factors can be used, and bank responses measured.
These are real and practical concerns from the supervisory perspective. While these concerns are warranted, tradeoffs exist between accuracy, complexity, and results interpretability. Leading banks already have numerous controls in place to test a wide range of financial and economic outcomes and prevent excess risk concentrations outside of CCAR. For example, firms with large trading books typically have market and counterparty limit frameworks that combine probabilistic and multiple deterministic measures (e.g. stress tests or scenarios).
Model limitations from potential structural breaks is a challenging issue for econometric models, one of many that developers and validation functions grappled with even before the 2020 pandemic or pervasiveness of digital banking. These recent phenomena have made forecasting even harder, and more flexible modeling approaches could help. Banks often employ challenger models or model overlays to compensate for these issues, subject to rigorous review and challenge.
On February 15, 2024, the FRB released the ‘Supervisory Baseline’ and ‘Supervisory Severely Adverse’ scenario paths and the ‘Severely Adverse’ market shock component. In addition, the FRB released two additional exploratory scenario paths and two additional exploratory market shock components.
In its release, the FRB highlighted four ‘elements’ of its exploratory analysis:
The explicit incorporation of funding stresses into capital stress testing is a new feature for CCAR 2024. The first two elements assume that banks face funding challenges and therefore incur incremental costs to maintain deposit levels and/or fall back on more expensive funding sources. The quantum of deposit repricing is based on observations from the March 2023 banking episode. Notably, these funding pressures are hypothesized to manifest under two very different sets of macroeconomic conditions, one mild and the other very severe.
The projections below show a few representative variable forecasts under the Supervisory Severely Adverse, Exploratory Macro Condition A, and Exploratory Macro Condition B scenarios.
Source: Federal Reserve Dodd-Frank Act Stress Tests 2024
As shown in the charts above, the Supervisory Severely Adverse scenario has characteristics typically associated with a severe recession, such as the one experienced in the US in 2008/2009. For example, US Real GDP drops sharply and takes more than a year to recover. US treasury yields rally and stay low due to monetary policy actions and inflation runs below the FRB’s long-run target. The Exploratory Macro Condition B scenario, on the other hand, has a more pronounced, double dip recession that occurs over a longer time period. Macro scenario B also presents dramatically elevated and persistent inflation and corporate bond yields.
The latter new elements represent two additional market shocks that apply only to the eight US G-SIBs. Just as in the Severely Adverse Market Shock scenario, these eight firms need to measure the instantaneous impact on their trading and private equity positions resulting from the shocks. The counterparty default component is different, however. Rather than the default of the single largest counterparty, typically another large bank, the FRB is requiring firms to measure the impact from the simultaneous default of their five largest hedge fund exposures. The focus on collateralized hedge fund exposures has been persistent since the large losses suffered by some firms from the 2021 Archegos default. The assumption of correlated hedge fund defaults is a new feature for supervisory stress testing, though firms with large prime brokerage businesses typically run a variant of this type of extreme scenario for internal purposes.
The market shocks in the Supervisory Severely Adverse Market Shock scenario and the Exploratory Market Shocks A scenario are quite similar for most asset classes though they differ in the shape of interest rate shocks and inflation expectations.
The market shocks in the Exploratory Market Shocks B scenario are quite dramatic, particularly the severe weakening of most currencies versus the US Dollar. US interest rates rally sharply in contrast to the interest rate selloff in the other market shock scenarios. The macro asset class shocks (foreign exchange, interest rates, and commodities) in this scenario tend to be directionally opposite to the Supervisory Severely Adverse Market Shock scenario and Exploratory Market Shocks A scenarios, which will likely surface a different set of ‘defaulting’ hedge fund counterparties.
The figures below show several representative variables (out of many thousands). Note that in all three scenarios micro assets (credit and equities) sell off significantly and therefore are not shown.
These changes have a notable impact on participating banks. Scenario complexity is increasing at a time when banks are under increased regulatory scrutiny and are intensely lobbying for changes to the Basel III Endgame proposal.
We expect banks to run these additional scenarios internally in parallel to the FRB. It is not clear to us if running the scenarios internally is mandatory, but firms will want to understand their impact and anticipate the FRB’s results and potential findings. We certainly expect the eight G-SIBs to run the additional exploratory market shock and hedge fund counterparty default components. The FRB has historically relied on these banks’ market shock and counterparty default results as the baseline for its supervisory results as it does not have the granular position or the pricing models required to fully conduct the exercise independently.
We anticipate three major themes in this year’s CCAR exercise.
Increased Complexity – Despite its maturity, CCAR remains a complex undertaking executed on a relatively tight and precise timeline. For many banks, CCAR execution involves hundreds of people across nearly every area of the firm. The largest banks employ dozens or hundreds of models, and significantly more if pricing models are included. Considering this, the introduction of additional scenarios will impact banks across multiple fronts, including scenario design and expansion, modeling methodologies, results execution, review and challenge, and documentation.
Strained Resources – As highlighted above, CCAR execution presents tremendous demands on banks. As banks grapple with the need to execute CCAR, they find themselves stretched thin due to an intensified exam focus from supervisors, specifically on the financial risk topics resulting from 2023’s bank failures. The FRB conducted exams in 2023 on interest rate and liquidity risk and the 2024 agenda continues to focus on these areas. Consequently, many of the bank’s same resources will be involved in both CCAR execution and adjacent regulatory initiatives.
Extensive Feedback – Given the heightened supervisory focus since last spring, and the new exploratory scenarios, it is expected that firms will receive material supervisory feedback. Exploratory scenarios, by their nature, will likely uncover issues that are challenging to predict. While it is impossible to know what weaknesses may be exposed, supervisors will be closely reviewing the results and are emboldened to act should they identify any shortcomings.
The stakes for CCAR are always high, as an unfavorable result can limit a bank’s ability to execute its capital distribution plans. This year’s exercise is taking place in the wake of last year’s bank runs that resulted in three of the five largest bank failures in US history. We expect significant scrutiny of banks’ results, including the new exploratory scenarios. Finally, we note that CCAR is taking place against the backdrop of the Basel III Endgame rulemaking process, which by industry estimates could increase bank capital requirements by an additional 25-30%.
1 Federal Reserve Board - Federal Reserve Board releases hypothetical scenarios for its 2023 bank stress tests
2 https://www.federalreserve.gov/publications/files/exploratory-analysis-of-risks-to-the-banking-system-20240215.pdf
3 https://www.federalreserve.gov/newsevents/speech/barr20231019a.htm
4 https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf
