OFR Issues Working Paper on Predictability of FRB Stress Test Results

The Office of Financial Research issued a working paper examining whether the stress test results of the Board of Governors of the Federal Reserve System ("FRB") have become more predictable and "arguably less informative."

According to the working paper, projected losses in the 2013 and 2014 stress tests "are nearly perfectly correlated for bank holding companies that participated in both rounds." The paper compares projected losses across different scenarios used in the 2014 stress test, and finds "surprisingly high" correlations for outcomes grouped by bank or by loan category, which suggests "an opportunity to get more information out of stress tests through greater diversity in the scenarios used."

The paper goes on to discuss the potential implications of these patterns for the further development and application of stress testing. According to the paper, one option for responding to the findings is to accept the greater predictability of the tests as a "consequence of the maturing of the stress testing process" and understand that a predictable process still has value. The paper argues, however, that routinized stress tests could lead banks to optimize their choices for a particular supervisory hurdle and create new and harder to detect risks in doing so. Another concern is that stress test predictability may lead to pressure to weaken the process because of the costs involved in its implementation.

A second option is to resist following the trend toward predictability by (i) differentiating between scenarios to bring greater diversity to the stress-testing process, (ii) expanding the overall number of scenarios and/or (iii) expanding the stress-testing process to include knock-on and feedback effects between institutions, as well as interactions between solvency and liquidity, "leading to a richer set of outcomes."