FED Paper Describes FLARE, A Top-Down Model for Stress Testing
FED published a technical paper that describes the Forward-Looking Analysis of Risk Events (FLARE) model. FLARE is a top-down model that helps assess how well the banking system is positioned to weather exogenous macroeconomic shocks. FLARE estimates banking system capital under varying macroeconomic scenarios, time horizons, and other systemic shocks. The paper describes the major model assumptions and the projection procedures and addresses how the underlying structures of DFAST and FLARE differ and how their results compare. The paper also outlines the current plans to enhance FLARE.
While Dodd Frank Act Stress Tests (DFAST) and the Comprehensive Capital Analysis and Review (CCAR) exercises are critical policy tools for assessing the health of large banks, FED has worked to build additional tools to assess the resilience of the banking system and to address macro-prudential goals. The Forward-Looking Analysis of Risk Events (FLARE) model is one such tool. FLARE complements DFAST in at least three ways:
- First, using publicly available DFAST macro scenarios, FLARE forms a benchmark assessment of banking system resiliency, as measured by changes in banking system capital.
- Second, FLARE is flexible. Its specifications are easily updated to reflect the evolving banking system financial conditions, the length of scenarios can be changed, and alternative data sources can be incorporated. FLARE’s modularity also allows satellite models to build in feedback effects and fire sales.
- Finally, because FLARE primarily uses public data, it can test the financial strength of bank holding companies, including those not in DFAST.
FLARE can be adapted to address macro-prudential stress testing goals. While the DFAST exercise remains critical to assessing banking system vulnerabilities and individual large bank safety and soundness, many macro-prudential policy topics, such as funding shocks and fire sales, are outside of the current structure of the public DFAST process. FLARE can be used to answer questions that may not be addressed by public DFAST scenarios. As an example, FLARE was recently used to assess the impact of prolonged low interest rates, reduced term spreads, and modest gross domestic product (GDP) growth on banking system performance. The tool also informs judgments of the resiliency of the entire banking system, not just large banks, and can be used to assess the relative severity of different macroeconomic scenarios. FLARE uses FR Y-9C data to project bank holding companies' earnings, losses, and capital under varying macroeconomic scenarios.
With respect to the future plans for FLARE, the model development will likely focus on two types of improvements in the short-term. First, several loan portfolios estimated in FLARE could be improved by including risk-taking data available through FR Y-14 and other sources. Similar to the refinements implemented for credit card net charge-offs, the first priority is to focus on incorporating risk measures that add to the macro sensitivity of the model and inform loss estimates. Second, to bring more depth to FLARE as a macro-prudential tool, the balance sheet needs to be more dynamic. As part of that, the current funding shock overlay can be improved and longer scenarios can be considered to incorporate a prolonged period of very low interest rates or a “double-dip” recession. In addition, the future versions of FLARE should estimate how fire sales may pose a risk to banking system resiliency.
Related Link: FED Paper
Keywords: Americas, US, Banking, Stress Testing, FLARE Model, Top Down Stress Test, DFAST, CCAR, Systemic Risk, Regulatory Capital, Fire Sales, FED
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