Opening Remarks - The Intersection of Research and Stress Testing

Speaker:

Lisa Ryu

Using Obligor Financials to Harmonize Bank's Internal Corporate Credit Ratings

Authors:

Carlos Gutierrez Mangas

Ivan Ivanov

Mark Lueck

Shan Luo

Joseph Nichols

Discussant:

Victoria Ivashina (HBS)

Abstract:

Banks use their internal credit rating systems to manage and track portfolio credit risk. However, there is a great deal of heterogeneity in the nature and structure of these ratings. Common practices are to convert these internal ratings into a consistent measure that is comparable across banks using processes that either require historical performance of loans under a consistently applied rating scheme over a long period or self-reported concordance mappings. Either of these approaches is still dependent on bank specific credit risk metrics that may not be comparable across firms. In this paper we use a unique supervisory data set to model the relation between internal ratings, obligor financials, pricing, underwriting and loan performance. We document ratings' incorporation of 'hard' information (financial statement fundamentals for obligors). In addition to the obligor credit rate the underlying risk of loan distress for specific exposure will be reflected in the pricing and underwriting of the exposure by the firm. We capture this by including loan characteristics when we estimate the probability that loans will become distressed, and we report that a probability of distress model based both on `hard' information and 'soft' information contained in banks' internal ratings provides better predictive power than internal ratings both at the loan-level and cross-sectionally at the bank holding corporation level. We find that our estimated probabilities of distress contain information beyond what is contained in banks' internal ratings.

Break

Disclosure and Stress Tests

Authors:

Mitchell Berlin

Discussant:

Gadi Barlevy

Abstract:

Should regulatory bank examinations be made public? Regulators have argued that the con…dentiality of the examination process promotes frank exchanges between bankers and examiners and that public disclosure of examination results could have a chilling e¤ect. I examine the tradeoffs in a world in which exam results can be kept con…dential, but regulatory interventions are observable by market participants, as they typically are for stress tests. Nondisclosure permits regulators to induce banks to communicate truthfully, but this requires regulators to engage in forbearance, which is priced into banks' uninsured debt, thus, raising the costs of inducing truthful communication. Regulators who disclose exam results bear higher monitoring costs and impose excessive capital requirements because interventions are not as sensitive to underlying risks. My model predicts that disclosure is optimal when the regulator's model is relatively inaccurate.

Keywords:

stress tests, disclosure, bank regulation

JEL classification:

G2, G21, G28

Evaluating the Information in the Federal Reserve Stress Tests

Authors:

Beverly Hirtle

Anna Kovner

Mark Flannery (SEC)

Discussant:

Deniz Igan (IMF)

Abstract:

We find evidence that the Federal Reserve stress tests (CCAR and DFAST) produce information about the stress tested firms, as well as about other non‐stress tested banking companies. Although standard event studies do not always show abnormal returns for the stress tested sample on average, we argue that such tests are ill‐suited for this sort of information event. We use a novel approach, showing that around stress testing announcement dates, the absolute value of the cumulative abnormal returns (|CAR|) of stress tested bank holding companies average more than 3 percent. Cumulative abnormal trading volumes are almost 2 percentage points higher than a market model would predict. Absolute value abnormal returns and volumes are higher for more levered and riskier firms. We explore several theoretical hypotheses outlined in Goldstein and Sapra (2014) and do not find evidence of negative welfare costs of stress testing disclosure consistent with these theories.

Lunch – Keynote Address

Speaker:

Jamie McAndrews

The Failure of Supervisory Stress Testing: Fannie Mae, Freddie Mac, and OFHEO

Authors:

Scott Frame

Kristopher Gerardi

Paul Willen

Discussant:

Scott Smith FHFA

Abstract:

Stress testing has recently become a critical risk management and capital planning tool for large financial institutions and their supervisors around the world. However, the one prior U.S. experience tying stress test results to capital requirements was a spectacular failure: The Office of Federal Housing Enterprise Oversight's (OFHEO's) risk-based capital stress test for Fannie Mae and Freddie Mac. We study a key component of OFHEO's model|the performance of 30-year fixed-rate mortgages|and find two key problems. First, OFHEO left the model specification and associated parameters static for the entire time the rule was in force. Second, the house price stress scenario was insufficiently dire. We show how each problem resulted in a significant underprediction of mortgage credit losses and associated capital needs at Fannie Mae and Freddie Mac during the housing bust.

Keywords:

Bank supervision, stress test, model risk, residential mortgages, government-sponsored enterprises

JEL classification:

G21, G23, G28

Improving Robustness of Operational Risk Modeling Through External Data Scaling

Authors:

Azamat Abdymomunov

Filippo Curti

Discussant:

Adam Ashcraft

Abstract:

One of the biggest challenges that banks face in modeling operational risk is the substantial instability of risk estimates from one period to the next. The key elements responsible for this instability are the heavy-tailness of loss distributions and insufficient loss data. To mitigate data limitations, the advanced measurement approach (AMA) under Basel II requires that the operational risk measurement system complements internal bank's loss data with relevant external data. However, the heterogeneity of external data makes combining it with internal data a challenging task. In this paper, we propose a scaling method to combine external and internal data, focusing on the tail of the loss distribution. The method is based on our finding that the loss severity of tail losses is related to bank size. We demonstrate that our method improves the robustness of operational risk estimates using supervisory operational loss data.

Keywords:

Operational risk, Basel II, Regulatory Capital, Stress testing, Loss scaling

JEL classification:

C22, C23, G21

Break

Idiosyncratic Shocks for Stress Test Scenarios

Authors:

Francisco Covas

Burcu Duygan-Bump

Rochelle Edge

Luca Guerrieri

William Nelson

Egon Zakrajsek

Discussant:

Rohan Churm (BOE)

Abstract:

We propose a top-down econometric framework for estimating capital shortfalls of bank holding companies (BHCs) that layers idiosyncratic shocks on top of a pre-specified macroeconomic scenario. Importantly, we are able to devise stress test scenarios that are impactful across all banks and do not depend on extremely severe macroeconomic outcomes. Our approach allows for the severity of the idiosyncratic shocks and of the macro scenario to be chosen jointly. Moreover, the magnitude of the idiosyncratic shock of each BHC is estimated based on their risk profile.

Keywords:

stress testing design, macroprudential regulation, stress tests, capital shortfalls

JEL classification:

C32, G21

Determinants of Auto Loan Defaults and Implications on Stress Testing

Authors:

Pavel Kapinos (FDIC)

Oscar Mitnik (Inter-American Development Bank)

Discussant:

Jerome Henry (ECB)

Abstract:

We propose a simple, parsimonious, and easily implementable method for stress-testing banks using a top-down approach that captures the heterogeneous impact of shocks to macroeconomic variables on banks' capitalization. Our approach relies on a variable selection method to identify the macroeconomic drivers of banking variables as well as the balance sheet and income statement factors that are key in explaining bank heterogeneity in response to macroeconomic shocks. We perform a principal component analysis on the selected variables and show how the principal component factors can be used to make projections, conditional on exogenous paths of macroeconomic variables. We apply our approach, using alternative estimation strategies and assumptions, to the 2013 and 2014 stress tests of medium- and large-size U.S. banks mandated by the Dodd-Frank Act, and obtain stress projections for capitalization measures at the bank-by-bank and industry-wide levels. Our results suggest that bank responses to shocks are indeed heterogeneous, and that while capitalization of the U.S. banking industry has improved in recent years, under reasonable assumptions regarding growth in assets and loans, the stress scenarios can imply sizable deterioration in banks' capital positions.

Keywords:

stress testing, banking, Dodd-Frank Act

JEL classification:

G17, G21, G28