Beverly Hirtle of New York FED on Supervisory Stress Testing Design

She detailed the design choices made for stress testing and highlighted three important tactical issues in supervisory stress test modeling that research can help address:

• Additional ways of projecting revenues and non-credit expenses in stressed environments is a particularly ripe area for additional work.
• Concerns about measuring model risk. How to assess errors from models intended to capture performance under stressed conditions when those conditions have not yet been realized and might not be in the historical data?  How to assess the uncertainty or margin of error around loss and revenue projections derived from models that can be quite complex, often involving multiple estimation steps?  How to assess the error around the ultimate calculation of stressed capital ratios? Howto measure correlation in model errors in a tractable and practical way? How much model risk owes to the decision to develop complex models for many individual pieces of the net income and regulatory capital ratio calculations, instead of using simpler, "top down" estimation approaches?
• Role of simpler, easier to estimate models of net income and its key components. Federal Reserve modeling teams have already developed a set of these "benchmark" models that produce loss and revenue estimates as a comparison to the projections from the more sophisticated and complex production models. Increasing deviations between benchmark and production projections could highlight emerging (or declining) areas of risk. A related area of research could address optimal ways for supervisors to assess the signal when benchmark and production model results deviate significantly from one another. Also, these simpler models could potentially form the basis of a more dynamic, system-focused stress test analysis that builds in the linkages and feedback not currently captured in CCAR and DFAST stress testing programs. 

Next, she highlighted issues where additional research could help guide the evolution of the supervisory stress testing regime. A related set of questions concerns how stress testing affects the cyclicality of capital requirements and what degree of cyclicality is appropriate. How does cyclicality of stress testing interact with other cyclical elements, such as the countercyclical capital buffer and the incoming current expected credit loss (CECL) approach to loan-loss provisioning? Finally, one concern that has been raised about the FED approach to stress testing and integration into the CCAR program is that of "model monoculture," which is the idea that banks will be "incented" to develop models that mimic the FED models rather than developing their own independent approaches: "Significant commonality in modeling approaches in the banking system could result in banks adopting similar risk exposures and hedging techniques, exposing the sector to additional systemic risk and potential future instability. How do we measure this risk? What should we think about differences (and similarities) between bank-generated and supervisory stress test results, both for a particular stress test cycle and over time? What disclosure and transparency policies about supervisory models can address these concerns, while still supporting insight and credibility into the DFAST and CCAR stress testing programs?"

She concluded by saying that these are the questions that challenge policymakers as the regulatory and supervisory regime that was put in place following the crisis is re-examined and evolves in the wake of that re-examination. "A disciplined analytical approach to these topics is critical in weighing future design choices, such as those made during the initial implementation of SCAP, CCAR and DFAST stress testing. Research on these topics could make substantial and meaningful contributions."

Related Link: Speech

Keywords: Americas, US, Banking, Stress Testing, DFAST, SCAP, CCAR, NY FED, BIS