Stress Testing: A Discussion and Review (Afternoon)

Welcome back everyone. I hope you enjoyed
lunch. Our keynote address today will be given by Federal Reserve governor and
vice chair for supervision Randall Quarles. Vice chair Quarles was
sworn as governor on October 13 2017 and began his current four-year term as vice
chair for supervision on the same day in December 2018 he became chair of the
Global Financial Stability Board prior to his appointment to the board
vice-chair Quarles was founder and managing director of the send more group
a Utah based investment firm vice-chair Quarles joined the Treasury Department
under president george w bush from april 2002 to november 2006 and served as
Undersecretary of the Treasury for domestic finance assistant secretary of
the Treasury for international affairs and policy chair of the Committee on
foreign investment in the United States he also served from August 2001 to April
2002 as the u.s. executive director of the International Monetary Fund without
further ado please give a warm welcome to Vice Chair Quarles thank you thanks thanks everyone for
being here thanks for coming back from lunch thanks to Lisa and to everyone
who’s contributed to the to the conference I think the morning from my
point of view it’s gone excellently I hope you’ve been getting as much out of
it as we have been this gathering comes just a couple of weeks after the
announcement of this year’s stress tests so let me begin by recounting the
highlights of those results at least as as I see them they show that our
financial system remains resilient that capital planning by banks continues to
improve the largest and most complex banks were tested against a severe
hypothetical recession and retained strong capital levels well above their
minimum requirements they demonstrated the ability to withstand a severe and
lasting economic downturn and still be able to lend to households and
businesses and additionally virtually all firms are now meeting the high
expectations that we’ve set to make sure capital planning takes into account
their specific risks and vulnerabilities that’s an improvement from last year and
overall these results are good news and confirm that our financial system is
significantly stronger than before the crisis and not just before the crisis
Timm stronger frankly than the system has been in our lifetimes now let me
turn to the purpose of this conference which is to sharpen our understanding of
the experience gained from stress testing over the course of the last
decade and to apply those lessons to think about the future and let me begin
by acknowledging that notwithstanding our openness to learning from the
collective experience of all of us in this room the future of stress testing
will in a number of important ways necessarily resemble the past for
example we’re still going to have them over the course of the last 18 months
I’ve heard overwhelmingly from academics from think-tanks of every stripe from
banks of every size from regulatory colleagues both domestic and foreign
that stress tests should continue to be a key element of the Federal Reserve’s
supervision of systemically important banks and a key aspect of the feds
efforts to promote financial stability stress test should continue to be
regular rigorous and dynamic and the banks performance on those tests will
continue to be the most risk sensitive and consequential assessment of the
affected banks capital requirements transparency around stress testing
process and results was a fundamental principle of the first trust stress
tests and of everyone that’s followed and it will remain a primary goal stress
tests as ever will provide the public with essential information to assess the
health of banks and of the financial system and to be credible stress tests
will also continue to provide significant information about how the
Fed does its work so the public can understand the rigor and independence of
our assessment process and how we come to form our judgment of the firm’s we
test fidelity to these principles embraced in the depths of the crisis by
that first stress test the decade ago does not mean that stress testing should
never change or that it hasn’t changed over the years we’ve learned from our
experiences with the early tests and already added useful features and
adjustments these include a counterparty default scenario as well as a number of
policy statements that more explicitly convey the principles we find important
in a sensible stress testing regime stress testing has evolved and must
continue to evolve to take on what we as supervisors learn from our work and what
we can learn from others each year we’ve refined the substance and the process of
the stress tests guided by our own experience
and by critiques and suggestions from others and this feedback comes from a
variety of sources including conferences such as this one and I’m confident that
the presentations today will provide insights that result in improvements in
our stress tests if stress tests are to continue to be relevant and effective I
strongly believe that they must continue to change they must respond to changes
in the economy in the financial system and in the risk management capabilities
of firms evolutionary change has been a consistent principle of stress testing
since the beginning embraced by my predecessors at the Board of Governors
and our supervisory staff and reflected in each cycle of tests without such
adjustments regulators banks and the broader public cannot get a clear and
dynamic view of the capital positions of the largest banks in an evolving system stress tests each year have upheld the
principle of transparency around the capital adequacy of our largest banks
stress test results should allow investors counterparties analysts and
markets to make more informed judgments about the condition of banks along with
other regulatory measures this transparency increases market discipline
and it subjects the Federal Reserve to greater outside scrutiny and analysis accountability is important not only for
some of the reasons mentioned today that apply in a democracy but also in this
case because stress tests can only be effective when the public has confidence
in the feds evaluation of the capital adequacy of banks I completely agree
with the statement made earlier that in effect stress tests are also a test of
the feds supervision of large banks so in these remarks I’ll first sketch out
how changes in regulation risk management the economy and overall
financial stability have prompted alterations to stress tests over the
past decade some of the current debate around stress
testing seems to suggest that stress testing sprang full-blown from the
forehead of Zeus in 2009 and we are only now proposing changes to it but the fact
is that it has been in a process of continuous evolution and much of that
evolutionary change has enhanced transparency which was a founding
principle of the stress tests I’ll then suggest some ways in which the
effectiveness of stress testing can be further enhanced with greater
transparency ten years ago in May of 2009 the Fed and the Treasury Department
released the first stress test results under the Supervisory capital assessment
program or s cap at that moment the US economy was in freefall United States
had lost an astonishing three million jobs in the previous four months one
significant reason for those losses was that many businesses were severely
constrained in their access to funding and found it impossible to predict when
that access might improve the goal of the first stress test was urgent and
simple to restore confidence in the 19 large banks then accounted for
two-thirds of the assets in the banking system in fact simply announcing in
March that there would be tests helped stabilize Bank finances that improvement
continued after the results in May outlined the quite feasible steps for
raising additional capital that banks would need to take and did take to be
able to continue lending if adverse conditions continued challenging
conditions did continue but the stress tests and other actions taken in the
first half of 2009 marked a turning point the recovery from the Great
Recession began in July of that year as the financial system came back to life
and then steadily strengthened the principles that made that first test so
effective were independence and transparency for the first time an
independent authority the Federal Reserve would seek to independently
assess risks just as important the details of that assessment would be
shared with the public an extent of transparency that until then wasn’t
characteristic of bank supervision but would become the hallmark of the
regulatory framework erected in response to the crisis
the first test as you all know relied heavily on bank’s internal risk models
but they still represented a huge step in Independence in providing the public
with an assessment of the health and resiliency of large banks transparency
facilitated both market discipline and accountability the information provided
to the public under the S cap stress test reinforced the entire enterprise of
estimating the capital shortfall faced by major banks it held the banks
accountable for information on their capital adequacy and required them to
fill the capital hole the next big step in the evolution of stress testing came
with its integration with the Federal Reserve’s comprehensive capital analysis
and review beginning in 2011 one big change from the initial S cab test was
that stress tests were no longer a one-time emergency measure intended to
restore confidence in major financial institutions instead they became a
recurring ongoing process intended to maintain confidence in major
institutions second stress tests were no longer a discretionary exercise by
supervisors under dodd-frank they became the law of the land
and third when they were integrated into seek our stress test became part of a
comprehensive that’s the first C framework for capital planning that more
closely connected capital regulation to risk management of banks and overall
supervision these were changes but with the effect of reinforcing the founding
principles of the S cap test transparency was enhanced when stress
test became mandatory recurring events and the public could depend on
continuing to have access to information about banks capital adequacy also the
independence of those judgments was enhanced
when Congress made them a statutory responsibility for the Fed and when they
were integrated into our seeker framework further changes to stress
testing over the years have likewise reinforced the original goals stress
testing scenarios have become richer and more challenging providing more
information about how banks would deal with a range of adverse developments and
for example exploring the effects of more differentiated risks that are not
tied to the business cycle large trading banks now face an instantaneous shock to
their trading assets and many participants in the stress tests now
must address how they would respond to the failure of their largest
counterparty our stress tests demonstrate that banks have now built
enough capital to withstand a severe recession the capital building phase of
the post-crisis era is now complete but as part of seek our stress testing
continues to contribute to the significant and ongoing improvement
since 2009 in risk management by banks the original reason for the qualitative
objection aspect of stress testing was to provide incentives for banks to
address the risk management shortcomings that the Fed had observed during the
financial crisis for example many firms that we supervise had substantial
deficiencies in their ability to measure monitor and manage their risks these
shortcomings made it difficult for banks to accurately report their risk
exposures to the board and concen consequently threatened to undermine the
credibility of the stress tests which were and remain dependent on data from
the banks since the beginning of CE car in 2011 large banks have significantly
improved their risk management and capital planning processes which is
hardly surprising it was indeed the objective of the exercise the
qualitative assessment conducted as part of the 2018 and 2019 seeker cycles found
that virtually all firms meet or certainly very close to meeting the
Federal Reserve’s supervisory expectations for capital
large banks have improved the methods they use to identify their unique risks
they now use sound practices for identifying and addressing model
weaknesses and they have strong processes in place to evaluate their
capital positions on a forward-looking basis so while we continue to perform a
qualitative assessment of course and ensure that that progress is retained
these improvements led the Fed to conclude that for most banks this
assessment can now be incorporated into our regular supervisory practices the
evolution of our qualitative assessment reflects the experience of the past ten
years of stress testing and in particular the great improvement in risk
management by large banks and the cumulative effect of the feds improved
supervision of large institutions as I said earlier for stress testing to
remain effective it must respond to changes in the economy the financial
system and risk management capabilities the changes to seek are have occurred in
the context of a similarly dramatic improvement in the strength and
resilience of the financial system the firms have more than doubled their
capital since the first round of stress tests in 2009 and since that time the
common equity of the largest eighteen firms has increased by more than 650
billion dollars well within the range that our estimates and well above the
range of estimates such as the Bank of England of the minimum necessary capital
in the system let me return let me now turn to the most recent changes to see
car and stress testing and put them in the context of the history I’ve just
related Congress revisited large bank supervision last year in s 21:55 the so
called Crapo bill but the legislation it passed reaffirmed the important role of
stress testing that shouldn’t be surprising because the experience of
stress testing over the last ten years as demonstrated to nearly every
participant that it is a highly useful element of large bank supervision and
they promote Financial Stability something else that
shouldn’t be surprising is that this experience has revealed that periodic
stress testing has turned out to be a less useful supervisory tool to evaluate
the risk of smaller and less complex financial institutions Congress made use
of this experience by raising the threshold for stress testing to a
hundred billion dollars in assets and providing more flexibility for the Fed
to tailor stress testing for all firms this step has once again advance the
principles demonstrated in the first stress test and ever since it has
increased transparency because incorporating and disclosing what we’ve
learned about the varying effectiveness of stress testing at different types of
institutions is making stress testing more effective the accountability of the
Fed is enhanced when we are seen taking on board what we have learned through
successive cycles of stress tests and this strengthens both the credibility
and the independence of our judgments for those of us who believe stress
testing should remain central to supervision and promoting financial
stability it’s vital that an adjustment such as this takes place where it is
appropriate so with that in mind let me review some recent changes and proposed
changes to the Federal Reserve’s stress testing practices these changes are
designed to make seek our more transparent and simple and to feature
less unnecessary volatility the first principle is transparency we’ve taken a
number of recent steps to enhance the transparency around our models and the
stress testing process more generally earlier this year the board published
enhanced disclosures on two of the key models that we use in stress testing in
addition we published estimated loss rates for groups of loans with distinct
characteristics to show how supervisory models treat specific assets under
stress will publish disclosures about two additional models in 2020 and each
year thereafter until we’ve provided transparency about all of our stress
testing models and at the same time we published a new policy statement on our
approach to supervisory stress testing among other things the statement
emphasized is the importance of independence and
stability to the credibility of our stress tests we’re currently considering
options to provide additional transparency regarding scenarios and
scenario design and I expect that the board will seek comment on the
advisability of and possible approaches to gathering the public’s input on
scenarios and salient salient risks facing the banking system each year such
a proposal may also provide additional details about the scenario design
features that underpins each year scenarios and a range of other
enhancements some argue that the greater transparency and disclosure promoted by
recent changes and proposed changes to stress testing amounts to providing
banks with the answers to the tests this both overstates the extent of the
disclosure involved and misunderstands what we’re trying to accomplish in
stress testing goals that haven’t changed since the spring of 2009 if the
goal were only to conduct a test that was difficult to pass like the
qualifying exams for some of the more esoteric and restrictive high IQ
societies then trying to explain principles and scenario design and how
models work would be inappropriate if the measure of success for the Fed in
administering a stress test was simply how many banks failed and greater
transparency would indeed be a mistake but that is not the purpose of stress
testing and it never has been the vitally important goal is to improve
and sustain good risk management and capital planning at the individual
institutions we supervise and to promote the stability of the financial system
like a teacher or at any rate a good teacher we want them to learn good risk
management in the context of forward-looking capital planning this
will provide the public with more information about the capital planning
of major banks and about how the Federal Reserve views good capital planning and
risk management bolstering our credibility the second principle reflected in recent
changes to stress testing is simplicity one important proposal what we’re
calling the stress capital would simplify the feds large bank
capital rule by integral integrating the stress testing process with our
traditional regulatory capital rules our regulatory capital rule includes both
minimum capital requirements and a buffer that sits on top of those minimum
requirements and the buffer serves as an early warning to a firm and its
supervisors and it requires the firm to reduce its capital distributions as the
firm moves through that buffer to approach its minimum requirements
integrating these two standards is a natural evolution of C car away from its
origins during the crisis when such tailoring was impractical and policy
makers hadn’t yet considered the approach of a regulatory capital buffer
on top of a regulatory capital minimum the stress capital buffer would result
in a more transparent and simplified system of regulatory capital
requirements because each firm will be held to a single integrated capital
regime it wouldn’t reduce the stringency of the regulatory capital framework for
large banks but would it would affect a substantial simplification of the
framework by my math a number of different capital requirements
applicable to large banks would fall from eighteen to eight
I don’t know that eight is a magic number but it’s smaller and the number
of total different loss-absorbing capacity requirements for large banks
would fall from 24 to 14 I expect that we’ll move forward with revised stress
capital buffer proposal in the near future reflecting many other comments
received on our original proposal the third principle addressed by recent
changes is volatility when I think about volatility and stress testing I want to
distinguish what I consider to be useful variation in the tests in the form of
exploration of salient risks from what I consider to be less useful variation in
the form of unexpected swings in capital requirements that don’t have any
particular relationship to the changing risks at individual firms in addition
one source of volatility in the test comes from the fact that banks are
forced to do their capital plan before they get the results of our tests
and I’ll address each of these concerns in turn in distinguishing useful from
less useful volatility one option to address the year-over-year volatility of
the test would be to average the results of the tests from the previous year or X
number of years this wouldn’t affect the overall stringency of the tests and
would still allow us to have a useful diversity in each year’s test to explore
different aspects of the responses of each banks and and the overall industry
portfolio two different types of risks but mathematically it would mean that no
single year could have an outsized influence on the amount of capital that
a bank is required to maintain potential downsides to this approach include the
reduced risk sensitivity that a bank may experience to a particular test
potential technical challenges associated with changes to a banks
balance sheet in earnings but bearing in mind these potential challenges I think
that more thinking and discussion of this issue would be fruitful with
respect to the second concern as I’ve said before I believe it more rational
and logical for firms to be able to plan for their capital needs with the benefit
of the results of our tests given the huge strides that the banks have made in
their capital planning and in meeting our expectations I view the risks of
banks banks backsliding in this regard to be minimal
because it would be evident in the next test our capital planning expectations
won’t decline and we’ll continue to use the Supervisory process to enforce those
expectations but it’s my hope that greater transparency can play a role in
other parts of our supervisory process for example by allowing other aspects of
bank supervision to benefit from public input greater transparency for
supervision is in keeping with one of the biggest improvements to the
regulatory framework and distress testing since the financial crisis I
believe the changes and propose changes that are currently
under consideration distress testing and that I’ve discussed today reinforce the
founding principles of that first test administered in the challenging and
uncertain spring of 2009 and reflect what we’ve learned each year over the
decades since then that process of learning and refining should and must
continue in order to keep stress tests as relevant and effective as they have
been in helping to reduce the chances of another severe crisis so thank you all
again for being here and I’m looking forward to taking some questions so we
are going to do the Q&A but I’m gonna start by asking if I share a couple of
really tough questions and so I’ll start by asking you know you heard some of the
discussion earlier today about some of the changes that we have made today and
you also kind of sketched out some of the additional changes they may be made
some I think part of the the public feels that we may be watering down our
requirements and do you have any response to that particular criticism so
I think so it’s a very sensible concern on the part of people watching the
evolution of the system to ensure that it does not result in a watering down
and I have no issue at all with public pressure being kept on to the federal
reserve to prevent that from happening I do think that when you look at the
specifics of what we have proposed as regulatory changes with respect to
stress testing or more broadly in the regulatory system that they you know
that I think that a dispassionate examination of them would say it’s hard
to say that that’s watering anything down given that we have been very
careful about that I don’t think that they should be watered down the issue
with stress testing for example has has not in my view has not been with its
stringency and so for that reason the very first stress test that we
administered after I arrived at the board was I think by everyone’s measure
the toughest stress test that had ever that had ever been administered one of
the reasons for that was a was an interesting although somewhat eccentric
assumption about the response of the slope of the yield curve in a position
of stress that’s not something that we would continue to maintain so this year
we moved back to a more natural slope of the yield curve and some of those
changes move that test move some aspects of the test back to what they had been
more similarly to 2017 which had been the most difficult stress test up to
that date but other aspects of this year’s test were more stringent even
than last year so again I think that when you dispassionately look at what
we’re doing we’re not reducing the stringency of the test and while I’m
sure they’d like to I actually don’t hear many requests from the industry to
reduce the stringency of the test I’m sure that’s strategic but the but
other things that we’re doing I think actually improve our ability to run a
good test the transparency issue is not about allowing the banks to somehow game
the system because I think we put measures in place as to how we’ve done
that that prevent that from happening whether you view compliance as gaming or
not I just don’t think that’s going to happen it’s about ensuring that we get
more input from everyone in this room which is not just the industry as to how
as to what we’re doing and I think we’ve already begun to get some input on the
increased transparency about models that we have that has not come just from the
industry of really oh now that we see this is that really what you meant to do
and you know and the particular questions that have come in that I’m
aware of it is what we meant to do but but that’s the sort of input that we
ought to be getting and responding to the second question is about actually
paper which will be presented on the third panel which will follow this
particular keynote speech and and Q&A and and it’s
it’s a paper in by nearly lange and don khon talks about certain features of a
currency call a stress testing regime where it has counter cyclical features
and and largely i think in their paper talks about how it was brought in by
inclusion of the of the share share repurchases and dividend in terms of
just as thinking is through the counter secure elements of a binding is of the
stress test and obviously you mentioned about the stress capital buffer which
that proposal includes elimination of the much of the pre funded the share
repurchases and so arguably they would bring down
counter cyclical kind of features of the current stress testing regime so i know
it’s a long-winded kind of framing of the question but the I guess the
question is I mean which is I think is that one of the questions I asked early
on an opening like can and should stressing yourself should be as counter
cyclical as as what we attempted to do if if the stress testing is not counter
secure what are the other elements if at all should we consider for the counter
cyclical purposes so so I think that’s a very good question and my own thinking
on this has evolved over a shortest period of time so I don’t want to steal
the thunder from the upcoming panel and presentation of the paper by discussing
it before they’ve had a chance to make their case as well as the other
discussants I mean I hope that it’s as much of a food fight as the first panels
have been because that’s really been quite useful and interesting I think
there was recognizing the limited number of counter cyclical tools that the
Federal Reserve has at its disposal I think most central banks have a limited
number of tools but we have a more limited number
tools and some of what we would consider our peer institutions there was a view
and certainly it was a view that I expressed when I first arrived at the
board and I think was a common institutional view that oh but it’s ok
because the stress tests are our counter cyclical measure and precisely because
of the almost automatic function of the lowering unemployment rate and other
features of the macro shock but that’s going to result in the tougher and
tougher macro shock as the cycle moves I think that over the course of the last
two tests we have been seeing the limitations of trying to use the stress
test as as our primary counter cyclical tool maybe even as a counter cyclical
tool at all you know that that was a sensible thing to try to assume but I
don’t think that it’s been working and I think we saw again with some of the as
we view this process perhaps continuing to exist for some period of time you’d
say well there’s just a limit to how counter cyclical we can make the stress
test so I’m not arguing that we should abandon the use of the stress test as a
counter cyclical tool but I do think that it it makes the potential
consequence of changes to it that could reduce its counter cyclicality less
consequential but it puts more of a premium on then what are we gonna do
with our other tools you know one of the obviously obvious one is the counter
cyclical capital buffer as to which there has been a lot of discussion and
and there well that’s a I don’t want to take up our entire time for questions on
stress testing with that so I might leave that for a separate time but
effectively I think there are good reasons we haven’t turned that on but in
part because given our where we have calibrated our through the
cycle both are through the cycle requirements as well as the density of
our risk-weighted assets given the stringent C of our stress tests I think
we have effectively relative to the rest of the world turned on our counter
cyclical capital buffer which is why when you look at the risk to financial
stability which we regularly do every quarter at the board and say are there
you know meaningfully above normal financial stability risks you see areas
of concern where you know there are elevated risk to financial stability but
the overall risk to financial stability is swamped by the extremely low leverage
in the financial sector that that causes the overall view to be well this isn’t
meaningfully above normal that’s just another way of saying
although it took me a while to understand the implications of that
repeated analysis that this is another way of saying our counter cyclical
capital buffer is on that creates issues for us if we want to turn it off at some
point in the future in in a future downturn because we don’t have the
ability to do that so I do think that one of the things at least that I am
learning from seeing the limitations of the stress test as a counter-cyclical
tool and becoming more skeptical of its ability to do that is that we need to
find some way to use the other tool that we have more as a way of being able to
turn it on in a downturn because I think the implication of our analysis is that
we’ve effectively turned it on permanently let me see if anyone has a
questions in the audience right here in the front anyone with the microphone can
you please announce your name and affiliation yes my name is Steve Marlon
I’m with infra produce observers magazine it was suggested in
the first session this morning that the stress tests have pores banks to base
their capital allocation decisions not on the fundamental economics of the
business rather on how it would impact stress test results and one possible
solution would be to split the the way the stress tests run so that the banks
could use their own individual models to calculate their own capital requirements
with the Fed using its models or economic purposes
have you considered or in you envision considering so that is something that
conceptually obviously that I have conceptually I’ve thought about it’s
something that the Bank of England has a good model for and and and we have
talked over the years to understand more about how the Bank of England process
runs it’s not something that is under however under active consideration at
the Fed for a couple of reasons I do think that there is one is as I
indicated in my remarks I do think the institution thinks that one of the
lessons of stress testing over the course of the last decade one of the
reasons for the higher confidence in the u.s. stress testing process relative to
you know again some of our peer regulatory processes has been that it is
that it is the feds view that we do have those separate models I think that that
has been useful another reason which sounds terribly mundane but as all of
you know since many of you have sat in these chairs when you sit in a chair
like this you have to take these things into account it’s incredibly doing that
is incredibly resource demanding the supervisor when we have talked to
the Bank of England for example they said well we do this because we believe
that it’s intellectually superior but we also do it to a handful of banks we have
no idea how you its enormous ly resource demanding on us
and so we have no idea how you would do it or the number of banks and the size
and complexity of the banks that you would have to do it or to actually
review all of their different models and come to a view on all of their different
models and interact in a way that was not excessively micromanaging with all
of that I mean it becomes a you know an exponentially greater logistical task as
you increase the number of banks that you’re supposing that to say that you’re
including in that process so so that’s not actively under consideration but it
is something that we have you know we haven’t simply brushed it off any other
questions I think there’s someone it’s right there in order to in and also why would you isn’t it a watering down okay so so with
respect to so with respect to the g-sib surcharge –is kind of be measured post rests within
the stress test actually I mean we have proposed to the to the great distress of
many people in this room I know but I have you know I I do believe that
intellectually measuring the post measuring the g-sib surcharge post
stress is the right intellectual construct for the for the reasons that
you describe given the purpose of the g-sib surcharge that is something that
that that should stay in place even post stress so I do think that intellectually
that’s correct that’s a separate question from whether
we have calibrated the g-sib surcharge appropriately and it puts a strong
premium on that question if it’s going to be in the stress test calculation
post stress then you know the fact that we have essentially doubled it over the
minimum internationally agreed over the internationally agreed minimum that may
or may not make sense but it certainly shines a light on whether that
calibration is correct and we said we’re looking at that in the context of the
overall capital requirements as they exist and as they’re going to evolve
over time that was something that a couple of people this morning mentioned
as well you’ve got a whole bunch of things that are still in the pipeline to
be implemented that could significantly affect the capital requirements of firms
and all of that needs to be thought about as a whole as opposed to piecemeal
the second issue though as opposed to the enhanced supplemental leverage ratio
and the and the leverage and where we have calibrated it and the fact that we
down down shifted the enhanced supplemental leverage ratio to the
internationally agreed standard it had also been higher that I think is kind of
that was a fairly straightforward optimization question I don’t view that
as a watering down I view it as a response to a regulatory incentive
that we had created to actually increase risks in the most sensitive part of the
financial system the insured depository institutions where the result of the
calibration where we had put it you know perfectly sensible if X is good to X
must be better so that’s that’s a perfectly sensible response but it had
resulted in the fact that for a number you know a number of our largest
financial institutions for their depository institutions subsidiaries
that leverage ratio that non risk sensitive ratio was their binding
capital measure and if you have a non risk sensitive measure as your binding
capital measure that’s that is a regulatory incentive for you to increase
risk in your portfolio because the capital charge for any particular asset
is going to be the same and so you ought to put on the asset that has the highest
return which will be the riskiest asset that that’s that’s a perverse result we
should not want to create a regulatory incentive for banks to increase risk in
in their portfolio anyway our banking organizations but certainly not in an
insured depository institution so it was I suppose it was fortuitous as much as a
consequence of precise calibration but by turning the calibration of that
enhanced supplemental leverage ratio down to the internationally agreed
standard it that had the effect of relieving the capital requirement at the
depository institutions but because of the rest of the capital framework not
materially relieving the capital requirement at the holding company so
that capital could now move out of the depository institution to the holding
company the overall amount of capital that could escape from the system is
only about four one hundredths of one percent from the holding company level
so that the depository institutions no longer had that perverse regulatory
incentive but the banking organization as a whole still had all the capital
that had been in it before and not only was it at feds traditional source of
strength doctrine that would allow that depository institution to be the first
claimant on that now freed capital in the event of some future stress but that
had been enacted into law in dodd-frank so that the depository institution was
the first claimant on that excess capital so you know when you look at
that you say that is just I think any anyone looking at that complex of facts
would say this is something that we ought to do it was not a weakening of
the system at all not at all so the the those are my response to those two
questions I think there were two separate questions but if I understood
them there’s a question right up front hi Victoria guido with Politico I wanted
to ask about the qualitative objection I know that you mentioned in your speech
that banks still go through a qualitative assessments and a lot of
people argue that this effectively means that the result is not any different
because the Fed can still punish banks for flaws in their capital planning
process but I was wondering what was the compelling reason to get rid of it is
there a public benefit to not having a qualitative objection I think that there
is I think that there is both a public benefit there’s a public benefit and a
supervisory management benefit for treating like things alike and we have a
lot of important concerns with respect to banking institutions that we engage
with them on in a regular supervisory process and in the media daftar math of
the financial crisis and for some period of time
what I would think what I think many people would think was perhaps a
surprising period of time after the financial crisis there was a there were
material weaknesses in an extremely important area for the banks in the
qualitative area of their capital planning it’s just a fact and again it’s
not surprising it was the result of that very heavy engagement with the banks
over the course of a decade that their capital planning has gotten much better
for virtually all of them and I would expect for those banks that still
haven’t made that transition they’ll be able to learn from the experience of
other banks that will probably happen faster all of that’s what how one would
expect the universe to evolve and that in a universe where capital planning is
now I would say at a par maybe even above the ability of the banks with
respect to other important elements of their operation that we also supervise
that we should supervise that in the same way and engage with them
holistically on their governance and controls essentially around capital
planning and around many other aspects of their operation and recognize that
this is what was an extreme deficiency has now moved up to sort of a level
playing field with other concerns there’s a question from Sharon we’re
sitting yeah hi Jared Siebert with Cowen watching a research group just a quick
question on dividends versus buybacks in this in the test we had heard for the
early years that there was a 30% cap on dividends that seems to have largely
disappeared but still there are some questions about how quickly banks can
turn dividends off and how willing they are to turn dividends off can you talk a
little bit about how you see the balance between those two capital distribution
tools well I think I you know I think I view them probably largely the same as
most people in this room I mean it is the case that it it’s harder both as a
practical matter and is a historically revealed fact to turn off dividends than
share repurchases but both are restricted and but as a consequence I
think any change to the to the dividend to the dividend pre-funding assumptions
and the stress test would have to be accompanied by quite a concrete and and
evident agreement on the part of the banks and the regulator’s that as one
choose into the buffer that would result in a decrease in distributions that that
would also affected dividends more rapidly than it
had in the past if the pre-funding assumption were going
to be changed it is the case it has it was always the case it was the case
before the crisis that was not just a bank problem the bank regulators have
always had the ability to prevent a bank from paying out dividends if they
thought that it shouldn’t and we didn’t turn off the tap any faster than the
banks did and so I think you know on the other hand it is possible for us to do
that and we should very clearly explain how we’re going to do that and that
we’re going to do that we have time for one more question and is a gentleman
right there in the middle hi Randy Bob Cisco Capital One I was wondering if you
would be willing to share your view of the odds of implementing this dress
capital buffer proposal for C car 2020 they are good it is at least I would
like to know the same thing it is it’s still our objective and I still believe
an achievable objective and a very high priority for me to have that done with
the appropriate responses to the to the comments for the next cycle unless if
there’s any other questions there’s one more question I think we can just take
that it’s right in the very front in the middle I John McDonald from autonomous research
just wondering about the interaction of Cecil with the stress test program and
what are your thoughts on the challenges of integrating that and if we do push it
off for a couple years but it seems like we’re going to what are the challenges
of banks kind of operating where the Cecil mindset and not using that mindset
in the stress test scenarios well as so it’s interesting I mean the the the
current reserving methodology really is different than what we use in the stress
tests right we have as opposed to looking at the bank reserves as opposed
to you know what is that what is the day one amount but the the reserving
methodology other than that doesn’t really factor into our projections of
losses and you know and the bank’s performance during the period of stress
and you know and our proposal for at least the first couple of years is that
that would you know that would not be the case I think actually that my
expectation although we learn a lot about Cecil I’m very open to learning
about Cecil during this phase in period more than a lot of people I think we may
find that there are consequences that we have to respond to I think a lot of
folks in the official sector believe that you know when we actually see how
it functions we’ll determine that there’s you know that there’s not a
required response from the regulatory cycle it’s not going to be as dramatic
in effect as people are thinking I’m certainly open to the view that it may
be a material effect that we have to respond to but I think that’s probably
likely to be easier to do in the stress testing environment than elsewhere and
may in fact have a positive effect for banks if it does increase the the you
know the the day one Reserve that banks have that’s just going to be more for
them to touch you through during the stress test and actually ought to
ameliorate the the effect of the stress but you know
we’ll learn how all of that works during the during the phasing process and are
very open to making changes if they’re necessary is not a it’s not a a phony
phase in at all to sort of pull the band-aid off slowly it really is what
will we learn during this phase thank you very much for Sherman for your
candid response and thanks everybody I think we’re gonna take about half an
hour break and come back at 3:30 you methods periodic assessment of financial
vulnerabilities and its new biannual public financial stability report
Andreas is another of the pioneers in the design oversight of the bank stress
tests that we have with us today please welcome Andres to the stage okay
hello and let me just take one minute to introduce the distinguished panel that
we have here it’s just extremely fortunate to have some very strong
thinkers of course Nellie Lange currently senior fellow Brookings
Institution my former boss till Sherman you know another person that we were all
in the foxhole with 10 years ago and and you know currently partnered Oliver
Wyman Jared Seberg managing director at Cowan group a talented ultra-marathoner
and Buzz Roberts president and CEO of the National Association of affordable
housing lenders Nelly’s going to give an initial presentation about 20 minutes
and then each of our panelists will give remarks and then we’ll have Q&A from the
audience so let me start by saying thank you very much one for everybody to come
back I know vice chairman Quarles already said that but this really means
at 3:30 we really mean this and thank you to vice chairman Quarles in the
conference organizers for the invitation to write a paper for this event and
contribute to the public’s input to the feds review of the stress test talk
about today is written by Don Kohn and me and I would start by saying we agree
fully with the vice-chairman stated objective which is to preserve the
strength of the stress test and to while improving efficiency and transparency
so we were asked to discuss to address the question of what are some of the
effects of the stress tests and this was on broader economic and financial
conditions now a challenge for writing this kind of paper is to separate the
effects of the stress test from the effects of all the other regulatory
reforms that have taken place over the last decade so we have of course higher
capital requirements and liquidity requirements and then banks own changes
in their risk management practices so we tried to frame our questions to try to
get to the stress test effects and so what did we focus on we tried to
separate them from higher regulatory capital requirements so what is that
that the stress tests are more forward-looking and based on tail risks
and they probably have different effects on bank risk management then say
regulatory capital requirements we used for this paper a lot of public data
available so I’m not at the Fed anymore so I don’t have access to some of the
data I used to have we also reached out and talked to many experts so in fact we
talked to 17 different individuals that represent the bankers the investors the
regulatory community and then we reviewed some empirical research so we
settled on three particular questions one have the stress tests helped to
counter potential procyclical ‘ti of bank capital so that’s one of the
features of stress test that distinguishes a regulatory capital table
to have the stress test improved risk management and capital planning at
tested institutions and three have the stress tests affected the cost and
availability of credit from the largest banks I would start with the big caveat
many of the potential benefits and potential costs of stress tests are
through a full economic cycle and we haven’t had that yet so we’re only
observing really can observe what’s happened so far which is we’ve
had an expansion without a downturn so I want to make that caveat but having said
that caveat to preview I’m going to say all our answers to all three of these
questions is yes maybe a qualified yes but yes but I think the answers are a
little more interesting than that so that’s what I’m going to talk about
today and we aim to provide you know answers to these questions in a way that
hopefully provide some insights to any proposed changes through the stress
testing program in the future so just to start on the first question stress has
capital program designed to make capital requirements less static help counter
pro cyclic allottee just a little aside there I think there was some question
about whether stress test should aim for counter cyclical I need to help counter
no cyclicality I think this one issue is with the large banks they are all
subject to the same systemic risks they’re all subject to macro shots it’s
hard for them to sort of hedge against macro shots of the u.s. system so this
is more that’s the counter cyclicality in some sense that you want you don’t
want them all to take big losses at the same time so that it’s that sense in
which counter said go colony or countering pro cyclicality is useful
there are two features of the stress test program that I would highlight
today one is the macro scenarios as you all know they can be more stressful when
times are good and can can include new risks and then there’s a second feature
which is it requires banks currently the current program to pre-fund shareholder
payouts and as you know see car is the binding capital requirement and the
pre-funding is of proposed dividends and share repurchases and then d fast which
is the formal stress tests required by dodd-frank but is not the capital
binding capital requirement it assumes dividends at the past rate annual rate
so it’s okay just start I mean just I mean use
some pictures um I’ve noticed but I like picture so I’m going to use some today
and hopefully they’ll help the discussion if you start with the right
this is the stress test capital buffer under C car which is the light or the
purple bars and DFAS which is blue and it’s defined by the decline in the
common equity ratio from starting to minimum okay which is where the where
the which is the constraint and as you can see this is 2014 to 2018 the purple
bars on net are up they’re not you know it’s not this straight upward trend but
on net their ups they’ve helped keep capital at higher levels and you can see
that on the Left chart which is you see the rise in common equity tier 1 it’s
risen and around 2014 it’s kind of stayed flat so I think the stress tests
are helping to keep that in capital at this higher sustain level in that sense
it’s had some benefits some of that of course is from the unemployment rate so
this is a chart you’ve all seen many times the macro scenario is often
defined by this unemployment rate so on the left here you get the from 2006 you
get the rise in the unemployment rate and the decline all those colored bar
colored lines are the different scenario projections and the the very last one is
the 2019 scenario the orange is the 2018 but what you see is the deltas keep
getting bigger and bigger as the unemployment rate goes gets better so
that’s the kind of counter cyclical ax T that has been built in and that is part
of the guidance that has been on the right is the triple be corporate
yield so I picked one asset price to to show here and you can see that also has
sort of the similar properties that when the spread is the yield is a little high
the increase is not as big where the spread is low the increase is bigger in
2018 you get a big rise this is the aversion to long term fixed assets that
was put in the 2018 stress test referred to earlier so this is introducing some
volatility some salient risks you can question you can argue about whether
it’s too volatile too uncertain but I think the idea that scenario should
capture real-world uncertainty is not arguable you know like you can’t you
don’t want more certainty in your scenarios than you feel then there is in
the real world they should reflect that so I think that whether that was the
right one people can argue about but I think that’s in some sense what the
scenarios are about but what I want to point out here is these unemployment
rate the deltas continue to rise each year the buffers have not so I think you
know you’re only going to get so far with the macro scenarios I wonder so
here’s the capital buffer where I’m gonna split it up between what I’ll call
the net losses and what are the dividends the pre-funded dividends and
this is I’m gonna use de fast capital buffers because we know what dividends
are and see car you don’t know proposed share a payout so you can’t really quite
get to it so this is sort of net losses and the blue bars are the g-sibs
and the orange bars are the non g-sibs and we’re looking only in this example
at domestic bank holding companies so there’s about eight of them there’s
eight of them and the blue and there’s about fifteen or eight seventeen in
in the orange sub clear is same story not a clear trend for the g-sibs their
substantial and this is a percent of risk weighted assets and then for the
non g-sibs there’s actually an upward trend these net losses have gone from 1
percent to 2 percent over this period so we do see some some upward trend and
then here’s the counterpart to it which is the dividends and to do dividends
what we did was we estimated the dividends that are in the capital ratio
to the minimum so our assumption is that the largest G says they’re binding
capital ratio their minimum kappa ratios at five quarters okay whereas for the
non g-sibs it’s at eight quarters so these dividends represent payments out
out to the minimum okay so you can see like the dividends for g-sibs look a
little lower and that’s partly because it’s five quarters and you see the
dividends for the non g-sibs are higher but they’re flat so DFAS buffers are
rising for the g-sibs from the dividends but it’s a small piece of relative to
the big losses they had and then the non g-sibs is more static the takeaway so
far and before I get to the share repurchase piece is the defense buffers
provide some counter pre-pro cyclic allottee you might have expected capital
buffers to fall given the improvement in the economy and the better balance
sheets and this is offsetting some of that but it’s the kit now let me just
turn to the next piece and I think this is the important part that this is just
set up the C carb is the binding capital constraint so that’s the one you
actually the bankers care about and and and there’s actually what causes
behaviour so here’s the share repurchases though
because we can’t observe proposed these are just actual and this is from 2014 to
2018 and the g-sibs you can see now that that is pretty pros that is trended up
sharply and for the non g-sibs it is also trended up sharply though the
takeaway here is that for the g-sibs you’re gonna get most of your Pro cyclic
ality most of what to counter the pro stick Ocala tea from the repurchases
plus a little bit from the dividends and you also get it for the non g-sibs so
this is going to emphasize the importance of the share repurchases
never to come back to those in a second so we wrote our paper and give it to our
discussants and several weeks ago but I just thought the 2019 results were
released so I just wanted to add this this is all the firms and we’re not
separating them but it reflects largely the g-sibs
I think what you’re gonna what this does is it reinforces this picture is gonna
reinforce that a lot of what is going on with capital buffers right now is from
the shareholder payouts so the black bars again are the de fast capital
buffers and those have fallen from 2018 to 19 and the difference between the D
fast & Seek are in 2018 and 2019 it’s quite large in 2019 so that’s the
proposed shareholder payouts now the C car buffers came down but they’re still
high so it’s you know I think you’re still achieving as I said it is
achieving it’s countering the pro cyclic ality it’s just doing it in different
ways now that I think are important for thinking about how to how you might
adjust your okay so we’re talked to a number of
people through this process and a couple of bankers actually raised some
interesting questions about how is stress testing actually work once a
recession starts so we talk about maintaining higher capital but like what
happens if an actual recession starts and you start to take losses and then
you have to specify a new C car and where are we and are we like is it is
the system resilient enough to avoid like causing firms in year one to start
pulling back because they know in year two they’re gonna get hit by a horrible
C car and so we what we did we to wait I don’t have a clear answer let me just
put that way I don’t have a precise estimate even though there’s gonna be
some numbers on these slides but I think you can set up a simple example to think
through this so that so that everyone can be prepared for this so the way we
thought about this is how much would capital decline in the first year if you
had a recession you’re gonna have some losses you’re gonna make some
assumptions about dividends and repurchases that you pay out and what we
did for this example we started with beginning of period capital which is
your n 2018 and let me just walk through the non g-sib so they start with 11.9%
capital an average non Driessen half we assumed half their losses from the
buffer so that’s one percent that’s the minus one then we assume dividends
continue to get paid out for four quarters that’s another point five and
then we assume repurchases are only paid out for two quarters and they shut them
off to zero for the second two quarters that’s an assumption that you can you
can change they end the year with 9.8 the g-sib starts with a little bit
higher capital 12.3 again this is an average maybe there is no such thing as
an average but average and they’re gonna take half their losses which is bigger
and they’re going to continue to pay out dividends and then they’re going to pay
out only half their repurchases do they end with 8.8 so what happens in the
following year so we have a recession what happens in
the following year the next scenario we can obviously there will be a next
scenario there’s guidance about it if there’s actually a recession the
scenario will be less severe so that works in that favor and then we can
assume that no repurchases and no increase in dividends but dividends
continue but there’s no increase then you can calculate what’s the maximum
stress test capital buffer that a bank could take before falling below four and
a half before the the supervisors would have to publish that your bank had
fallen below four and a half and so I think here the non g-sib it would be
four point three that’s a pretty big number but and the range over the last
five years is between one and two so it’s pretty unlikely they’re gonna end
up being binding if they have shut off all their share repurchases also now the
g-sib though you’re at three point six the range has been you know three and a
half to five and a half so they’re kind of in there so we’ve already so I think
this example and this is a very simple example it’s in the table and the paper
and you can kind of just change numbers in it the average non g-sib is almost
certain to be above a minimum but the average g-sib is going to be closer to
the constraint and and I get again to emphasize this assumes one and a half
quarters one and a half years of repurchases have been shut off that’s
about two percentage points of capital so this really is highlighting the the
importance of the share repurchases so two aspects as I mentioned contribute to
this the severity of the scenarios you can reduce the scenario scenario
severity and you probably will and I think that’s the appropriate thing to do
and that’s the way the guidance is there will be some limits on that because once
a recession is underway investors are going to want some assurance that banks
can kind of survive the recession and won’t contribute to it so there’s gonna
be some kind of limitations and you can go and then of course you’re
starting capital ratios is the other sort of thing you can maneuver and so I
think the underlying principle if you have iron net losses and higher
dividends you should probably have higher starting capital ratios as I said
share repurchases have been a significant loss absorber one ways the
alternative is the g-sib surcharge another alternative is the counter
cyclical capital buffer some combination but these are all trade-offs in terms of
avoiding capital falling so that banks are going to have to try to raise equity
in the middle of a recession so to answer the stress has helped to counter
potential political callate yes bill more from the requirement to pre-fund
shareholder payouts than the macro scenarios at least in 2018 and 19 have
the stress test question two and I’m gonna have to go through these a little
more quickly and this dress has improved risk management and capital planning at
tested institutions and we as I mentioned we talked to at least 17
individuals and the answer is yes absolutely and most believe they were
driven importantly by the public qualitative assessment and there’s a
very broad agreement on improvements there’s better data better risk
identification and measurement people are looking at tail risk they’re
assessing the capital implications of these tail risks there’s much stronger
governance in a link between risk and capital planning the chief risk officers
are talking to the chief financial officers these there’s a there’s just
risk management on a much more holistic basis there was a little less agreement
on whether the public assessment is still needed and most expected some
backsliding and I think there was some expert septons that that’s acceptable
because there has been the bar has been raised
Don and I kind of as part of pushing out it would really be great we we talked to
everybody we asked everybody how do you measure this and there isn’t do you know
form there’s just not a good measure and it feels like if the supervisors want to
remove the qualitative objection which they have and it seems there is a public
benefit to that it could be replaced is there something to replace it with that
would be useful to discipline not just the banks but the supervisors like how
do you couldn’t how do you continue to convince the public that the supervisors
understand what is what is happening and I’ll one other aspect of the cap of the
risk management is the capital plans are much more conservative some of this I’m
sure is from the implicit 30% payout you can see total payouts this is mean total
payouts to risk weighted assets have grown up a lot over the last few years
to the right you can see that the share that is the dividends of the total
payouts is much lower now than in the pre-crisis and given dividends are much
stickier than share repurchases which are related to pre cash flow this will
add to the resilience of the financial system once a stress hits okay I’m gonna
say just a couple of things on the last bullet third question have the stress
tests affected the cost and availability of credit from the largest banks we
reviewed a number of papers a number of very good papers and there’s a table in
the our paper that highlights the data that’s been brought to the issue how
they try to identify this dress test and some of the basic results one takeaway
is it’s pretty difficult to isolate the exact effect of the stress test given
all the other things that are going on but we would conclude from these studies
that credit from the stress tested banks is has been reduced but total credit
might not be so there are higher loan spreads less credit and these loans
though are less risky for the banks who have the larger stress test capital
buffers now there are some studies that actually can use
level data and can control for demand a little bit better so it literally
borrowers and which the borrowers from can borrow from which bank sub and you
know based on their stress test offer or their come use county level data so
large business borrowers in general will get less credit from the large stress
tested banks but they have many alternatives including smaller
commercial banks and capital markets smaller businesses have fewer
alternatives that is for sure but the market level data suggests that overall
credit grows at the market level is not really it does not fall so there’s some
evidence of substitution to smaller banks and some evidence of substitution
to non banks so our takeaway on this is bank credit from the tested banks is
reduced but it may not be a bug of the stress test it might be a feature but I
think the there some more work here could be done clearly credit growth was
very rapid before the crisis and there’s strong evidence of higher default rates
for non local market loans and the reforms clearly were intended to reduce
some credit growth in exchange for reduced probability of failure of the
largest banks who have the greatest externalities so there still needs to be
done a welfare analysis of the credit provision of less from stress sets to
banks and more from smaller commercial banks or non banks and then another
factor I would just mention as studies have looked at transition effects these
are short-term effects and long-term effects of capital requirements in
general have been shown to be lower when you have the ability of monetary policy
to offset or other policies to offset higher higher
I think that’s our takeaway there though our question is just to summarize of the
stress test help to counter potential Pro cyclic allottee of bank capital
which is necessary to support lending our answer is yes which should help
support lending in the next recession which i think is a good goal no more
from the requirement to pre-fund shareholder payouts in the macro
scenario in the last two years have the stress test improved risk management and
capital planning at the tested institutions yes absolutely
and driven driven importantly by the public qualitative assessment though
that doesn’t mean that public qualitative assessment needs to be
maintained just means something needs to be done though I think and then three
have the stress tests affected the cost and availability of credit yes they it
has it’s reduced the credit but this may be a feature rather than a bug and of
course the caveat to the we haven’t seen the how this all plays out over time so
thank you very much till will be our first discussant thank
you I’m about to learn the calibration of my progressive lenses to see if this
see how that works out so first thank you andreas for your kind introduction
and I really want to thank the conference organizers for inviting me to
join this this panel to talk about one of the things I like to talk about most
something that’s near and dear to my heart and that is in fact stress testing
so stress testing was the tool of choice to help write the financial ship during
and after the great financial crisis describing a concrete scenario that
banks must survive and in fact survive well is relatively easy to understand
and it’s relatively easy to communicate and in the middle of a crisis good
communication is a real virtue in 2009 the US bank stress test the iscap which
covered as governor quarrels reminded us about two-thirds of the US banking
system as banks to be able to absorb loan losses exceeding those that
actually happened during the Great Depression I think that’s pretty
convincing and in fact comforting and apparently at
the time so did the market and the public it worked so well in fact that
banking systems of countries representing more than half of world GDP
now have stress testing as part of their regular bank supervisory process it’s
hard to overstate that’s the impact that stress testing has had on banking
stability both as a tool to help us get out of the financial crisis
and thereafter as a program to regain and maintain stable resilient and
healthy banking system the us through the C car program has been leading the
way both as a financial crisis first responder and also in the migration to
financial peacetime stress testing now in its ninth year here in the US
other countries have been watching this experiment we’re running and there up
death adapting a lot of the practices but they’re not adapting all of them so
against this backdrop Nellie and Don’s paper represents I think an important
assessment of the most advanced and sophisticated but also most intrusive
stress testing regime across the globe they’ve done a remarkable job
I think of providing much like seek are a quantitative and a qualitative
assessment of that program so when the quantitative side my takeaways were
first the importance generally of buffers so this is a big change from
pre-crisis it was introduced in the iscap in 2009 you know this notion that
you want to be prepared for the crisis and you want to do that with a capital
buffer to make sure that you remain above the minimum this basic idea was
then formalized in the Basel three approach to capital adequacy it
recognized that a bank needs to be able to survive not just one but multiple
hits after a shock that eats away your buffer you still need enough capital to
keep going with market confidence and maybe survive some more losses for me
the most impressive rising finding of their paper though is the relative
importance that capital action pre-funding has played in both the
amount of capital build-up and the counter cyclical effect in since you
know the maturing of the program so if crisis or wartime stress testing
is primarily getting capital into banks then peacetime stress testing is really
thinking about the conditions that regulators might get comfortable with to
let capital back out of the banks so it’s really adds at that sense a short
step from wartime stress testing to peacetime capital planning Mellie and
Dawn’s exercise of working through what might happen following a serious but not
extreme recession where capital depletion is about half the past stress
tests which to be sure that is a pretty severe recession for that to happen I
think is especially instructive since attests this idea of buffers a lot more
directly now on the qualitative side as one
migrates from crisis to financial peacetime you could afford to and indeed
one should really concentrate a lot more on the qualitative aspects stress
testing is really useful for this much like the SAT same tests same time same
conditions everybody has to sit down and take it
same number two pencil do that anymore I know dating myself so the u.s. is the
only country that however that has a formal pass/fail for quality of
assessment at least still and the author’s note that perhaps the only
thing that all their interview is agreed on was that this helped to improve risk
management control practices and banks my own experience certainly corroborate
this finding and it’s it’s startling at least to me how much further the US
banks have advanced on this front than banks elsewhere at least that’s for my
own observations and that’s those of my colleagues so note that the supervisors
day job has always been to conduct qualitative assessment of banks
practices to ensure that they conduct their business into a safe and sound
manner but the concurrent stress test program has proven to be especially
useful and in an especially powerful tool for this task
moreover the public nature of the qualitative fails really focus the minds
of senior management and boards an observation that the course also made by
nilly and done other regimes use the stress test is a valuable input there
over supervisory assessment as well the European approach is to use capital as a
mechanism to motivate banks to improve their risk management control processes
but without resorting to outright public failure judging by some of the past
failures in the u.s. of highly capitalized even post stress banks on
qualitative grounds US regulators don’t seem to view capital as a substitute for
poor risk management a point of view I agree with so I want to place the u.s.
program in the global context and compare see car to the EBA the European
Banking Authority program for banks throughout the EU so the US economy is
up just under a quarter of world GDP the EU is about the same so by looking at
these two regimes we cover almost half of world’s world output so here are just
a few differences that I think are worth noting
so first the EBA conducts a stress test only every other year a cadence that the
u.s. is also contemplating dividends and cherry purchases importantly do not need
to be pre funded through the stress scenario if a bank finds itself
depleting capital through the scenario they can stop the Sherrie purchases and
even dividends to husband capital in order to pass the post stress hurdles
within limits of course this approach actually is also part of the C car
program but not under the Fed scenario it’s only so under the bank’s own
scenarios under the so-called alternative capital actions now this is
clearly more realistic as Nelly’s analysis of the capital distributions in
her crisis example or her severe recession example shows but supervisors
are understandably skeptical of what banks might claim that they might do
when confronted with a monster of financial crisis especially you know
since at the time it might seem just like a little monster
the EPA does not explicitly fail banks for qualitative reasons something the
u.s. program is already dropped of course for large but non complex banks
and is in the process of phasing up for all banks instead they incorporate the
learnings of the stress testing exercise into their overall supervisory
assessment of the bank which may result in additional capital requirements I
want to return now to this this notion of buffers which i think is a really key
feature both of the secret program but also really the whole post crisis
regulatory regime the u.s. program has generated average capital depletions
between three and four percentage points of CET one capital which is this metric
that of high quality capitals the metric also that that nelly uses it’s
essentially it’s essentially figure two of her paper so when you include the
evident and cherry purchases you essentially add another one or two base
one or two percentage points to this number the damage for g-sibs is higher
it’s like four to six percent on average without the dividend increase in sherry
purchases and one reason for that is that they have to add this counterparty
default that the other banks do not have that are not subject to now this extra
absorption actually is not all that far from the average jiseop buffer these
banks have to hold the European experience is similar the EBA and it’s
three runs so far as a resulted in a four percentage point average depletion
pretty much steady from year to year the Bank of England’s program which is now
in its fifth year is a bit higher it’s been between three and six percent
so this gives us a concrete idea of the kind of resilience to economic and
financial shocks that we expect whether they said the regulator’s expect banks
to weather the scenarios that the that the authorities effects banks to live
through are at least as severe and in most cases more severe than what we
actually experienced during the financial crisis now that’s important
because if we’re collectively able to judge the stress testing programs we
should look both of the inputs at the scenario is it really severe enough but
also we have to look at the resulting damage is it plausible given the
scenario that we’re looking at so we’ve taken at least some lessons from the
financial crisis quite seriously banks need to hold at least double the
required minimum amount of capital enough to absorb a severe shock and
still meet the minimum after the shock to be able to provide credit to a then
limping economy and get it back on its feet that in reality of course banks are
holding a lot more than just double the minimum requirement now this narrative
of layers and buffers to absorb shocks is especially pertinent for the g-sibs
and we asked them to hold war and thus be able to absorb form these abstract
buffers and numbers are made concrete with a intuitive language of stress
testing and resulting impacts on banks it helps us to understand whether the
capital requirements that we impose on banks are big or small are high or low
let me wrap up mm by just reflecting on the fact the memory of the financial
crisis is receding it’s been a decade in the US and as of this month’s month
we’re experiencing the longest post-war economic expansion we’ve been enjoying a
long stretch of financial and economic peacetime but the peace that follows a
crisis eventually involves evolves into the time just before the next one I
don’t know what that crisis is going to be but I do know that the risks that
dominate the agenda of the risk organizations at banks and other
financial institutions are actually not financial they’re non-financial cyber
technology even climate are though are the issues that are preoccupying chief
risk officers in my view rightly so frankly I don’t really worry all that
much about a financial market crash were severe economic downturn bringing the
banking system to its knees but we can’t be complacent and just pat ourselves on
the back for a job well done and building resilience to all these
financial and economic shocks we need to focus a lot more attention on the
non-financial ones so expanding stress testing to include a wide range of non
financial shocks I think is the real frontier the Bank of England’s
contemplation of including climate climate shock in its biannual
exploratory scenario in 2021 I think is a really interesting idea so on that
cheerful note but you know what did you expect from a stress testing conference
when my remarks thank you till and when till said that
the expansion is the longest post-war expansion the United States he of course
was referring to the war of 1812 I think this might be the longest expansion and
since the NBER you know record-keeping began with that Janet great thank you to
the Federal Reserve for inviting me to this conference thank you to Nellie and
Dawn for very thoughtful paper and of course thank you to everybody who is
still here I thought for sure once the vice chairman finished his remarks that
everybody was going to flee to enjoy the beautiful outdoors and I appreciate you
persevering through our final panel um I think work like this really is critical
because it’s so easy to forget what it was like in September 2008 and how much
damage the financial crisis did to the economy globally and to families at home
as such I think everyone can agree on the value of having a well capitalized
banking system that can clearly survive financial shocks the issue of course is
where do you draw the line and how do you evaluate proposed changes to the
stress testing regime so I have a interesting job I am both Washington and
Wall Street yes that means in some circles I already have two strikes
against me and my ultrarunning lifestyle may very well be that third strike but
it also means that I have a unique perch that lets me bring both a political and
a market perspective to this conversation and as a sell side analysts
I will give you my conclusion upfront the s cap C car regime was part of the
Trinity that saved the financial system from claps unlimited Deposit Insurance
stopped runs on banks and the liquidity initiatives kept markets operating the
Supervisory capital assessment program however is what made it possible to
invest again in the banking as it restored trust in how the
government measured solvency to quote chairman Powell or at least the remarks
that we saw him say even if we didn’t quite hear him say it the stress testing
quote helped restore confidence and stabilize banks by providing a credible
and independent picture of their finances as such I believe each change
to see car must be evaluated through the lens of whether it enhances the markets
trust in the government in the next severe economic downturn and in how the
government is going to evaluate the health of banks in that situation my
concern is that some of the changes already implemented and others being
considered may erode the markets trust in see car as a measure of solvency and
I believe if this continues it may endanger political support for stress
testing and it may make the next banking crisis even more challenging to manage
so let’s spend the next four or five minutes and dig a little deeper into
this and I promise I’ll I’ll keep it to under 10 total
so my experience in 2008 being in Washington and being in the industry is
that the market lost confidence in how the government measured solvency when
FHFA put Fannie and Freddie into conservatorship just a few months after
the government urged investors to buy GSE preferred stock in effect the
government said to ignore the previous reported capital levels because those
numbers were so inaccurate that Uncle Sam had to seize the company imagine
that if you’re an investor one day you think they’re solvent the next day
they’re not the market’s confidence in how the government measured solvency
took a further blow when Lehman Brothers failed the market’s expectation was that
Treasurer in the Federal Reserve would not permit an investment bank to
collapse because of crisis induce the quiddity in capital troubles bear
stearns was supposed to be the resolution model we can debate endlessly
whether that was the right model or not but that was the expectation at the time
what I noticed at this point in the crisis is that our clients the
institutional investors out there stopped evaluating bank solvency based
on the tier 1 capital ratio instead they looked at tangible common equity on the
theory that this was pure loss absorbing capital if there was enough loss
absorbing capital then the government could not seize the bank and wipe out
their investment and even then there were doubts about this Kappa about this
calculation to me that is what made the Supervisory capital assessment program
so important the government put the 19 biggest banks through a tough stress
test and told the market how much capital they needed to raise to ensure
those banks would survive and evolve fill that capital hole with government
money if the private market did not step in this gave investors trust on how the
government would measure solvency this is not just because of the stress test
it was also because the market believed that government only would invest in a
bank if it intended to let that bank stay in business it was this taxpayer
exposure that gave the market trust in the S cap result meaning something the
end result of this newfound coffins that these banks were able to raise the
capital needed as my fellow panelists were talking about the May 7th 2009 s
cap released in my view represented the end of the banking part of the Great
Recession so then the Federal Reserve came along and it crafted C car to
further cement trust in the system and they added the qualitative review not
only was the government now telling investors how much capital the big banks
would need but it was also reassure during the market that these banks were
managing risk and planning for their capital needs in other words the market
could have added confidence in the solvency of banks that pass the
qualitative assessment so now we have proposed changes to seek are both those
implemented and those proposed to me the discussion of those are the critical
part of Nellie and Don’s paper as I see it these changes are uniformly positive
for the bigger banks in the short-term reduces volatility around seek our
results and that the margins might even offer some capital relief changing the
assumption on distributions would further benefit these banks and might
permit them to increase distributions beyond current levels and providing the
results before the bank’s submit their capital distribution plans could ensure
no Bank is embarrassed for using the Mulligan although why banks are
embarrassed for using the Mulligan still baffles me to this day the same is true
with the sharing of more details about how seek are functions that should
further help ensure that banks never fail seek our and these are all ideas
that much of the market and most of our clients would cheer yet I will argue
today that some of these short-term positives could be a long-term negative
during the next crisis and as someone who also worked through the savings and
loan crisis it was my very first job out of college following finish as it moved
through Capitol Hill I know the Great Recession was not a one-time event there
is going to be future economic turmoil in future banking crises s cap and seek
our work because the market trusts the government will respect the result the
issue is see car evolves as whether that trust will remain my concern is that
this could go the way of tier 1 capital that measure became so diluted that
neither the market nor the government took it as the serious measure of bank
solvency we’re see car to lose credibility it could make it difficult
during the next economic downturn for banks to raise
fresh capital which could further exacerbate financial turmoil and lead to
more failures and more instability and that is a problem because politically
trust me politically there is no support for rescuing the financial system again
we are not going to have tarp 2.0 and if one could craft a rescue package the
consequences would be severe enough to make dodd-frank and the other post
crisis reforms look minor in comparison to be clear there’s room for change the
vice chairman today noted that the stress capital buffer proposal would
reduce from 18 to eat the number of different
capital requirements that apply to banks and the number of measures of lofts
absorbing capacity would drop to 24 to 14
those changes may very well be warranted and beneficial one can protect
confidence and still provide pragmatic relief but my message today is that each
change to the see car regime must be evaluated for the lens of whether it
increases or decreases market trust in the results and there should be
trepidation about adopting changes that hurt the long-term market confidence in
SI car thank you a final discussant but you may need to
just advance the slides get that clicker so good afternoon and I
want to thank andreas and the Fed team for including me in this I want to talk
a little bit about what appears to be an unnecessary harmful side effect of
stress testing on access to investment capital for affordable housing and
communities because asset classes are broad in seek our protections on
investments and sectors that can be risky and severe stress scenarios can
also curtail investments in more stable sub classes that are both important
economically and socially more specifically constraints on
merchant banking activities of holding companies in high-end real estate is now
constraining investment in affordable housing that performs with relative
stability even through a financial crisis and banks are the primary source
of this kind of capital for affordable housing in part because they’re
motivated by the Community Reinvestment Act and because other private equity
investors are primarily interested in affordable housing in so far is that
they can remove its affordability so there aren’t a lot of good alternative
sources to the banks so how does this work so under C car the Fed specifies
assumed loss rates for financing activities of six US holding companies
and five international holding companies that are subject to global market shock
and these companies have 46 percent of all US domestic banking assets about 6.8
trillion dollars in a severe stress scenario the assumed loss rate for
investments in real estate are 45% and that for affordable housing is almost
prohibitively high for banks to consider and the feds caution in real estate
investment is understandable and well-founded except for affordable
housing and other so-called public welfare investments banks themselves are
generally prohibited from investing in real estate and so the Fed’s policy
primarily affects holding companies which have been using merchant banking
authority to make investments in luxury real estate and sometimes for trading
purposes in the crisis investors in speculative real estate did suffer
significant losses price bubbles have appeared especially in some markets like
New York so for example Stuyvesant Town and Peter Cooper Village an 11,000 unit
apartment complex in New York City built after World War Two commanded an
unsustainable six billion dollar price and that was based on the false
assumption that the middle-income residents of that housing could be
replaced by higher income residents who would pay much higher rents and support
a much higher value that failed kind of spectacularly and but other less
spectacular real estate investments also failed in some cases this is because of
unfortunate timing of a development process building a high-end condominium
or rental apartment building or office building that’s been started but not
completed when the crash hits sometimes meant that those buildings remained
and the investments failed so these are a little out of frame you can see
actually from this slide the blue sector represents high-end apartments it’s
about twenty-two percent according to this measure of the multifamily market
the remainder are sort of Class B in Class C equivalent properties and they
really represent the other twenty-two percent and those tend to be affordable
to low or moderate income households a rental housing is disproportionately
geared to lower and moderate income households as most middle and upper
income households are homeowners so C car though applies equally to luxury
housing and most affordable housing now there is a notable exception for
investments based on the low income housing tax credit which if we were to
flip back to that other table would show that banks are you must assume only a 5
percent loss rate on housing tax credit investments so that’s about 1/9 of the
loss rate for other real estate but tax credit properties represent about 20
percent of all the affordable rental housing stock so that leaves an awful
lot of stock that is still subject to the higher loss rates the policy problem
is that affordable multifamily properties performed differently and
more stable than speculative investments in luxury multifamily properties so that’s because luxury apartments are
more vulnerable to demand variations only high income tenants can afford high
rent apartments and they can easily shift a home ownership or in an economic
downturn they can simply choose lower rent properties if they need to you can
see that they actually jumped one extra so you can see here that most of the new
apartments that are produced are Class A or high-end Apartments and that exposes
the high end to the risk of over building on the and you can see that the
Class A the Green bought the green part of the bars represent about ninety
percent of all new deliveries of Apartments in contrast the supply a fort
of affordable rentals is actually declining because the modest number of
new additions is offset as formerly affordable units are upgraded and rents
are increased so not surprisingly we see that vacancy rates for Class A
properties are higher than for affordable properties the yellow line is
Class A and the black line is B and the gray is is Class C and the Green Line
which is labeled affordable is subsidized affordable housing in it similarly capitalization rates are
significantly lower for class-a apartments than for Class B and C
apartments and that reflects a built in expectation that luxury apartments will
increase in value more rapidly but of course in a severe stress scenario if
demand for luxury apartment stagnates or drops those property values are going to
deflate much faster and indeed we saw a cap rates much more volatile for Class A
multifamily properties through the crisis than for Class B and Class C
apartments in fact affordable properties perform quite well through the Great
Recession there’s a lot of data on tax credit properties and the accounting
firm Cohn Reznick found that the financial quote the financial crisis
appears to have had an almost no adverse impact on the overall health of the
housing tax credit inventory which marks a striking difference compared with the
impact of the recession on conventional multi-family housing and they also said
that consistently high occupancy rates are another indicator of the tremendous
imbalance between the increasing demand and short supply of affordable housing
properties and unfavorable economic conditions led to enlarged tenant bases
for affordable properties so the cumulative foreclosure rate for tax
credit properties has remained under 1% we can also see similar kinds of
performance differentials in other ways this is a Fannie Mae’s multifamily
performance compared with its single-family performance you can see
multifamily serious delinquencies these are 90 day delinquencies stayed under 1%
through the crisis whereas single-family serious delinquencies went exceeded 5%
we see similar results on bank loans these are 30-day
delinquencies and you can see multifamily stayed under 2% so it’s
interesting that other Fed policies explicitly accommodate affordable
housing and community development investments and that’s primarily through
this construct of public welfare investments which are limited in volume
and limited in purpose and and also in other investment terms so the Basel
three space capital rules require for other private real estate equity of 400%
risk weight but for public welfare investments only a 100 percent risk
weight and similarly the Volcker Rule has a carve-out for public welfare
investments and this is consistent with the board’s stated policy to enable bank
holding companies to take an active role in the quest for solutions to the
nation’s social problems unfortunately see cars inconsistency with this broader
policy unnecessarily undermines it and so we think the policy deserves some
reconsideration as part of the updating to see car thank you very much buzz Nellie do you
feel the need to rebut any of the okay so I’ll I’ll go to a couple of questions
so first an easy one you know stress tests are dynamic you
know the the weird talking about you know changes to the whole stress testing
program if you guys look down the road five ten years what are the challenges
and opportunities and stress testing till God you know I was pointed in that
direction I guess this is both like what should we have up on the whiteboard back
at the office and you know what are some of the challenges that that might be
coming down the road that we need to think about and we can go down the line thank you
well I showed my hand a little bit earlier but let me expand on this this
this idea so first I think making it easier to have sort of a richer more
varied I think one of the real really terrific features of the Bank of
England’s program is the explicit consideration of what they call this
exploratory scenario they they do every other year which is by design at least
the one that we’ve seen so far which was two years ago you know really quite sort
of creative and there in that particular case it was threats to business model
from FinTech and it also said you know don’t worry about the nine quarter in
their case it was said the standard horizon think a little bit longer so
having a mechanism in a framework that allows us to be a lot more creative
about the kinds of scenarios that would explore I think for me would be most
desirable longer-term or medium-term future you know I think you need to sort
of bifurcate this issue I think what’s made seek are effective is that it’s
focused on financial performance economic downturns and the like
the problem is that probably the new risks are beyond that it’s you know risk
of cybersecurity and what happens if you do have a breach of a bank it’s the risk
of the future of a payment system what happens if we don’t use dollars but we
all you know use sucks I’m sorry I mean Libra and you know I
mean there’s bigger business model risks that I don’t know what those need to be
part of the formal C car but the I assume they’re things that regulators
already are stressing these banks on and I think those need to continue and
accelerate I just reiterate that as C car revolves we’re looking for a little
bit more consistency between it and other regulatory policies especially in
areas where banks have a unique role in advancing social and economic issues before we turn to the to the audience I
mean there’s one question that is just you know it’s it’s it’s come up many
times today and you know is front and center in in nelly and Don’s paper so
you know they have a million don have a nice little example what they sort of
work out you know if we actually go through you know it’s a moderate
recession at some point you know it’s at least possible that depending on timing
and losses that some of the larger banks might be required actually to raise
capital as a result of the stress test and you know certainly would have a you
know undesirable effect on cap credit availability and so forth it’s
sort of precisely the wrong moment so you know what
what is to be done about this I mean you know till I don’t know if in an
international setting you know there’s a you know some consensus on how to
approach this this sort of the issue you know if there Jarett if there policy
issues you know buzz if you have some thoughts on the cyclical behavior some
of these asset classes and their sensitivity to credit supply well I
think so you know one of the things we’re learning by one of the reasons I
wanted to have this international comparison is just to get us a feeling
for a wall what what are the the size of the shocks has measured not so much in
the the scenarios because those are much harder to compare across countries but
rather and outcomes that we that the Supervisory community seems to want
banks to be able to withstand because the global standards for what the
minimums are are both everybody has the same ones and what’s remarkable to me is
that actually there is broad agreement on what is that buffer and it’s like I
said it’s about three or four hundred basis points so you know if to degree to
which we take if we take very seriously this well you know that’s maybe not
quite enough for the g-sibs or even for other banks then I think with the the
Supervisory community has itself what is then the appropriate amount and what is
the mechanism by which to do that is it – in the US we already have an
additional shock for the g-sibs should that be even larger but I think that we
have a language within which to have this discussion already you know I’m not
sure why it needs to be a negative that a bank would want to make raise more
capital during a downturn I think if you know I think that’s part of banking
nobody says that you you know nobody says you need to keep a hundred cents on
the dollar for every dollar that you lend out and if there’s if the market
trusts the the numbers and the market trusts
the management team you know I think we’ve seen that banks have the ability
to raise capital you know I’m not quite sure if I’m as convinced that they’re
going to need to you know they’re earning lots of money and they have the
ability to retain those our needs but I wouldn’t view that as a negative outcome
just because that’s a possibility you don’t have much to add on this maybe I
can add a little to that I think the issue of raising capital in a recession
is only because that’s the most costly time for a bank to raise capital it’s
not their first choice of one to raise and you’re right they can raise it and
if investors have confidence in their soundness and it shouldn’t really be an
issue but I think you’re you’re just right you’re just forcing a trade-off of
should I raise capital or shall I cut loans and or cut dividends and those are
difficult choices and from a stability perspective I think you want the banking
system to continue to provide credit through downturns so that it doesn’t
amplify the downturn make it worse that’s so for the diehards in the audience we
have a few minutes to take questions from you just a warning that in addition
to a mild case of face blindness I have a not so mild case of actual blindness
so if I if I if I don’t see your hand up just wave it stronger oh so I’m sorry
I’m sorry okay we’ve got a question right down here my name is Joe Riley and
the president and CEO of the Community Development trust very we’re a national
investor at affordable housing we’ve been in business for about 21 years
we’re a privately owned double bottom line company we have a mission to
provide long-term capital for the preservation of affordable housing we’ve
also got investors who are expecting a return on their on their investment the
owners of CDT are mostly banks and insurance companies I’d add that we’re a
we’re a CDFI we’re a community development financial institution we’re
a member of the Federal Home Loan Bank of New York and we’re an approved Fannie
Mae affordable housing lender we’ve done work over the past 21 years that has
positively impacted about 125,000 residents in in about 45,000 units
affordable units all over the country and I just like to follow up on some of
the comments that that that buz Roberts was was making at CDT we’ve actually
been directly impacted by the issues that that buzz has raised there have
been some banks who have told us they would gladly invest in CDT but for the
manner in which seek our treats this type of investment it seems to me that
it’s probably an unintended consequence that above what is a very important and
very valuable initiative overall but I think it’d be hard to imagine that that
the intention of stress testing would be to discourage investment in affordable
housing a resource that that is in such great need all over the
country right now earlier today governor Quarles suggested
that from a regulatory standpoint it’s a good thing to treat like things alike
and I would encourage the Fed to do that to do just that treat like things alike
I would encourage the Fed to to treat an investment in in entities like CDT which
support the preservation of affordable housing as public welfare investments
the same treatment as current the current treatment for low-income housing
tax credit investments both support the the development and preservation and
affordable housing and I think that that’s they are they’re alike and we
should treat them alike thank you for that that you know just when we when
when we talked to buzz before before this event you know took us a while to
sort of understand you know what the issue is and just to be clear I mean I
think this is an instance where a particular asset class is being subject
to the global market shock but it is a whole to maturity asset and there’s you
know it’s it’s certainly worth revisiting this question of whether it
is something that that we should think about the losses associated with the
instantaneous market market losses that we would as with other sort of things
that are in the trading book of it this is a true die hard question in the sense
that it’s very wonky but I Nellie I’m just looking your paper which I thought
was was great the the overall impression given by some of the data you had was
that the the stress tests were fairly counter cyclical and it held up quite
well over the economic cycle but I was thinking that if you if you adjusted for
the change in the treatment of a balance sheets over that cycle that it would
make a difference because at the beginning back in 2014 15 16 the Federal
Reserve was projecting increases over the stress period and bank balance
sheets of over 15 percent and that reflected the experience of the fight
nancial crisis were in the first over the first three years there were
increases in in the bank’s balance sheets and now we’re moving down to no
increase in in bank balance sheets and I think if you incorporated that you’d see
that that that change plus what you discussed with with the change the the
stopping pre funding in certain areas and other changes that are happening
where we’re getting pretty close to almost a procyclical
kind of move in the the stress capital buffers so I was wondering if anyone
might have any comment on that fully agree that the risk weighted asset
assumptions have have made a difference we were just trying to for presentation
today simplify it down to two pieces risk weighted assets were increasing
earlier there now by assumption being held flat so that would have added more
as you say I think going forward it’s a reasonable assumption to be flat though
it’s it was a difficult added uncertainty that wasn’t clear it
exceeded the benefits of a non static balance sheet so it’s one of the
trade-offs so could certainly be put in and yet one more lever to move to ensure
cyclicality going to start calling on people if we
don’t get enough questions thank you Steve for Citizens Bank if see car has
in fact resulted in a contraction or restriction of credit availability in
return for less risk in the system in many ways it has broad implications
beyond just the scope of stress testing and even this symposium has anyone
considered taking all of this data and building effectively a Markowitz
efficient frontier but systemic risk on the x-axis and credit availability on
the Y and then you could have a debate much like what we were just talking
about with the availability of credit to certain sectors or certain asset classes
so CNI crea fordable housing and then of course somebody would want to figure out
what is that tangency portfolio what is the optimality now it has broad
policy implications and when we were talking about transparency because
everybody’s going to want to know about those models it might turn this
morning’s food fight into a erect homecoming parade but has anyone thought
about doing such a study it’s kind of a geeky discussion sorry about that so a
couple of thoughts here I think there’s a view about historic rapid credit
growth and the increased probability of a financial recession so there’s some
move towards trying to understand what’s the like optimal amount of credit
then there’s credit growth and then there’s the composition of who holds it
and if it’s the institutions whose failure would have large systemic
externalities then it’s you’re better off by sort of redistributing some of
the credit provision if it’s so there’s there’s lots of dementia it’s not just
total credit it’s also distribution I think people are thinking about it but
it’s very difficult so there’s a lot of research that has happened over the last
decades since the crisis about how bad to rapid credit growth can be you know
so it’s after the fact we’ve started to understand some of the issues and I
think there’s pretty compelling evidence that you know very rapid periods of
growth unsustainable sort of it’s a separate financial deepening from
excessive credit growth can be costly it leads to a recession and those
recessions are more costly so that’s the piece that you have to make some
assumptions about how long the recession would be how deep the recession would be
and we’re learning that they’re actually quite much more costly than one would
have thought and so I think those are that’s a goal of researchers and
policymakers everywhere but I don’t think we’re there yet and no yeah I mean
I think it was my reading of your paper anyway is that a lot of these studies a
little bit of a flavor that the affected institution changes its lending behavior
but perhaps that you know the total amount of lending you know to to that
particular class of borrowers may not be affected because there’s pick up from
smaller institutions that’s right so the welfare of whether the less
credit from the stressed institutions and more at the smaller institutions
that’s something hi I’m I’m Joe Capone of source fund
management and I’m effectively a longtime investor in Bank global banking
financial equities um one observation I and most of my colleagues have made over
the years is that US banking is one of the only industries where they were not
demonstrable economies of scale in fact there are some diseconomies where the
largest banks are banks currently have often lower return on assets and
certainly some lower return on equity then there are smaller peers I think
that’s one of the reasons why there’s so much pushback on stress-testing broadly
but I had a theory I wanted to run by the panelists and see if this makes
sense or not um as an investor I’ve sort of thought that at some point if stress
testing actually worked that the markets would eventually Accord those that are
subjected to the stress tests with a lower cost of capital and potentially a
lower cost of funding in the debt markets and while it may take a
recession to sort of prove the value of stress testing in terms of an
institution’s ability to weather the storm or perhaps even profit or monetize
it we’re just wondering if any of you think that that’s something that could
really occur at some point they think if that were the case I think you’d see the
big banks sort of embracing the process more than more than I see from my scene yeah maybe I’ll tackle that first you
know I certainly agree in theory Joe but you you argued I’m just not sure if
we’ve seen that in practice even if you look at narrower industries the mortgage
insurers before the crisis there were some a couple of years earlier who had
much higher credit ratings and they didn’t feel like they were getting
rewarded by the market for that higher level of capitalization and so I’m not
I’m not convinced that you’re gonna see that reward unless we we do go through a
tough economic cycle and and the big guys come through with with flying
colors that that might be enough to change opinions but certainly not in
advance of that afraid here I have to sort of go back to some of my uh my my
old research activities which actually were from before the crisis the
economies of scale it’s really interesting insight some of the research
we reviewed for this paper which was the effects of the stress test on credit
provision suggested that the stress has butters and the bosses banks pulled back
from markets where they didn’t have branches so they had sort of extended
into areas where maybe they didn’t really have efficiencies or sort of
economies of scale or scope and that was the first place they pulled back and so
what you saw was the credit provision shrinking in markets that they didn’t
have branches in and you also saw the defaults rising in the markets we’re
further distance from local branches were you know that was where they were
highest so I thought those were pretty interesting insights it goes back to the
business of banking and some sense of like you know is there private
information between the lender and the borrower that
banks can provide and I don’t know how much scale there is to that but it’s
really okay well going once going twice bill shit you want to wrap us up here
thank you very much everyone for the remaining diehards on on behalf
of the board and the Federal Reserve Bank of Boston I’d like to thank
everyone for participating in this great day of discussion and debate and in
particular let’s give one more round of thanks to all of our presenters
moderators and discussants and just as a reminder for those of you who couldn’t
get enough or for the people who missed it all of the papers and and the video
of the conference are now available on the conference website and everyone have
a safe trip home you

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