FRB Vice Chair for Supervision Barr Promotes Improved Stress Testing
Commentary by Steven Lofchie
Federal Reserve Board ("FRB") Vice Chair for Supervision Michael S. Barr promoted incorporating "exploratory scenarios" to address limitations in the FRB's current stress test program for the U.S. banking system.
In remarks before the Stress Test Research Conference at the Federal Reserve Bank of Boston, Mr. Barr identified several limitations of the current stress testing system. These include the following:
(i) the current stress test uses a single scenario focused on a credit-driven recession and a single global market shock, which cannot cover the range of plausible risks faced by all large banks;
(ii) the models used in developing supervisory models are generally trained on historical data and may not be robust to structural breaks or significant changes in technology; and
(iii) the stress test could negatively affect bank behavior by disincentivizing firms from investing in their own risk management as the test becomes predictable.
To address these problems, Mr. Barr proposed the use of multiple exploratory scenarios in the stress test program. These scenarios would not be used to set a firm's stress capital buffer requirement, but would inform the Board's supervisory assessments of firms' risk management and understanding of different risks in the banking system. He said that additional exploratory stress test scenarios could allow supervisors to better probe the internal risk management of firms and assess whether they are holding sufficient capital for their risks.
Commentary
The Vice Chair's proposal for additional "exploratory" stress testing does little to blunt criticism of the FRB's failure to miss the impact of inflation on asset values. At least judged in retrospect, it is hard to imagine how inflation was not a principal concern of the financial regulators under its current stress tests. It makes one wonder how much of the FRB's attention was distracted from economic factors by other concerns (e.g., climate stress testing) and the extent to which the distraction might have been driven by political considerations.