March 18, 2022

Testing Bank Resiliency Through Time

Sergio Correia, Matthew P. Seay, and Cindy M. Vojtech

Summary

A resilient banking system meets the demands of households and businesses for financial services during both benign and severe macroeconomic and financial conditions. Banks' ability to weather severe macroeconomic shocks, and their willingness to continue providing financial services, depends on their levels of capital, balance sheet exposures, and ability to generate earnings. This note uses the Forward-Looking Analysis of Risk Events (FLARE) stress testing model to evaluate the resiliency of the banking system by consistently applying severe macroeconomic and financial shocks each quarter between 2014:Q1 and 2021:Q3. We evaluate resiliency using two measures. The first resiliency measure is the banking industry's post-stress minimum level of common equity tier 1 (CET1) capital ratio.1 The second resiliency measure is the banking industry's capital buffer shortfall, or the amount of post-stress CET1 capital that would be required to bring all banks to their total 2021 CET1 capital requirements.

First, some background on stress testing is required. Since 2011, the Federal Reserve has conducted annual stress test exercises that help the largest U.S. bank holding companies (BHCs) identify and address potential financial vulnerabilities.2 The annual stress test is a public exercise that shows how large banks would withstand financial stress. The exercise features a "severely adverse" macroeconomic scenario designed by the Federal Reserve, which generally follows patterns similar to the experiences of the 2007–09 financial crisis. In addition, the exercise requires some banks to submit at least one of their own macroeconomic stress scenarios that reflects risks that are most salient given their views on possible adverse paths of the macroeconomy as well as the exposures and activities of the bank.3

Discussion

The next shock to the banking system will likely look different than prior experience. Thus, studying banking system resiliency under alternative severe scenarios, as we do in this note, helps to uncover possibly underappreciated vulnerabilities. Given the flexibility of the FLARE model design and its placement outside of the supervisory structure, the possibilities for changing model specifications and scenario designs are much broader than what can be done through the annual stress test exercises.

Applying a variety of scenarios also helps improve the capabilities of FLARE. As a top-down model, FLARE has limited ability to assess some vulnerabilities, such as cases where banks substantially change their business operations and risk tolerances. Moreover, if the model is merely calibrated based on a narrow set of vulnerabilities, it is likely to miss certain risks. Thus, we must stay vigilant about model risks and misspecification. FLARE will continue to evolve and to test alternative methodologies to better understand the relationship between resiliency of the banking system and its relationship to the macroeconomy.

1. The CET1 ratio equals common equity tier 1 capital divided by risk-weighted assets. Return to text

2. This note will conduct analysis at the BHC level but will use the term bank and BHC interchangeably. Return to text

3. For example, in the 2019 annual stress test exercise instructions, BHCs are told to submit scenarios "appropriate to [the bank's] business activities and exposures, including any expected material changes therein over the nine-quarter horizon" https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20190306b2.pdf. Return to text

4. The term "top-down" means that the model uses bank level data, as opposed to a bottom-up model that would use more granular data such as loan-level and security-level data. Many of the models used to project losses in the annual stress test exercises are bottom-up models. FLARE primarily relies on FR Y-9C data that is at the bank holding company level. The macro variables are a subset of the 16 domestic macro variables in the annual stress test exercise scenarios. Return to text

5. The 200 largest BHCs are included in the model, plus an additional pseudo-BHC that aggregates all the remaining smaller BHCs. Return to text

6. We assume annual asset growth of 4 percent, consistent with recent recessions. We also assume risk-weighted asset (RWA) growth of 4 percent. More information on FLARE is available in the technical paper available here: https://www.federalreserve.gov/econres/feds/files/2022009pap.pdf.

7. Bank-submitted scenarios only include nine quarters of data. The trends in the bank scenarios are continued so that they extend to thirteen quarters to forecast loan losses in FLARE. Return to text

8. In FLARE, loan losses are estimated using net charge-offs (NCOs). Return to text

9. Evaluating banks' stressed CET1 ratios relative to individual banks' 2021 CET1 capital requirements provides an intuitive comparison of capital requirement breaches through time. There are at least two potential drawbacks to this approach. First, banks' risk profiles evolve with time, and 2021 CET1 capital requirements may not align with banks' risk profiles in prior years. Second, the annual stress test scenarios are designed to preserve capital requirements during expansions and release capital requirements during stress events. Using the individual banks 2021 CET1 capital requirements does not account for changes in macroeconomic and financial conditions in prior quarters. Return to text

10. Most banks with projected capital shortfalls exceed the regulatory CET1 minimum ratio requirement of 4.5 percent and remain solvent. Banks with shortfalls are subject to capital distribution limitations. Return to text