Federal Reserve Governor Daniel Tarullo doesn’t want banks to get too comfortable when it comes to testing. Therefore, banks, which have for some time lamented the inconsistent approach to the Fed’s stress testing, had better get used to the twists and turns.
“[S]tress tests must be modified so as to avoid incentivizing firms to correlate their asset holdings or adopt correlated hedging strategies,” Governor Tarullo said Friday in prepared remarks for a Yale Law School conference. To that end, he said, the bank will keep changing the type of market shocks it uses in its tests.
Gov. Tarullo suggested the idea of changing the tests from year to year sprung from the shock of 2008 and then the follow-on shocks of the succeeding years, i.e. the eurozone stresses and interest rate volatility. “The shocks, designed to be severe, consisted of instantaneous, hypothetical jumps in asset prices based on those observed over the entire second half of 2008,” he said. And even though the losses were big in the testing, the Fed felt banks should be ready for even bigger. “[H]ad we simply used the same shocks that we used in the 2009 exercise, unchanged from the historical experience, we would have underestimated the potential losses associated with subsequent developments.”
Thus it will behoove banks to out-worse-case-scenario the Fed when it comes to figure out what’s coming next. As was noted in a key takeaway from last spring’s NeuGroup Bank Treasurers’ Peer Group meeting, banks must actively consider differences in their own stressed capital ratios and those of the Fed; and to have solid explanations at the ready to back up their models. That’s because where the Fed does not fully believe in the input data or model being used, they will tend to default to the most conservative assumptions. In many ways, having convincing explanations is likely as important as the complexity of the model. It is better to have a simple model with excellent validation of both the model and its inputs, than a complex model that nobody can explain.
In the meantime, get ready to keep ramping up the models, because the Fed will continue ramping up the stress. “We will continue to modify the market shock regularly to incorporate salient risks that were not necessarily present in 2008 and to ensure that firms cannot artificially improve their performance on the test through holding significant amounts of certain assets that happened to perform well in that period,” Gov. Tarullo said.