Federal authorities are working on expanding the parameters of stress test scenarios, according to Attorney General Barr
The Federal Reserve is set to expand its stress test for the nation's largest banks, aiming to provide a more comprehensive assessment of their financial condition. According to Michael Barr, the Fed Vice Chair for Supervision, this move is crucial for identifying weaknesses and improving the resilience of the banking system.
Currently, the stress test uses a single scenario focused on a credit-driven recession and a global market shock. However, Barr believes that considering a small number of scenarios can capture a wide range of outcomes for the banking system. He stated, "It's important to consider what would break the institution, rather than thinking of a stressful scenario and then seeing how it would play through on a bank's balance sheet."
In line with this, Barr has discussed the possibility of introducing multiple exploratory scenarios to better probe potential risks on bank balance sheets. These new scenarios will be exploratory and not used to set a bank's stress capital buffer requirement.
One such exploratory scenario, introduced this year, is an "exploratory market shock" aimed at testing whether the trading books of the eight largest banks could withstand inflationary pressures and rising interest rates. The results from this shock were used as a study to help the central bank decide future test scenarios and how they are conducted.
The Fed has not yet revealed how many exploratory scenarios will be added to next year's test, or what they will examine. However, Barr emphasised that the central bank's stress test needs to continue to evolve to provide sufficient coverage of severe but plausible scenarios that could adversely impact a bank's operations.
The Fed's annual stress test for the largest banks is designed to ensure they can withstand a severe recession. This year's test, which included an exploratory market shock, saw all 23 banks examined remaining above their minimum capital requirements.
The failures of Silicon Valley Bank, Signature Bank, and First Republic Bank illustrate that banking strains can emerge even without a severe recession. Barr mentioned that while the stress test is important, it has limitations and the goal of stress testing should be to provide sufficient coverage of severe but plausible scenarios that could adversely impact a bank's operations.
Barr also mentioned the idea of reverse stress testing, which could be a more pointed tool to measure a bank's resilience. However, he did not specify what the reverse stress testing would entail.
It is worth noting that no information about purchasing licensing rights was provided in the article. The Federal Reserve is developing additional hypothetical scenarios for next year's stress test, but there are no relevant details regarding the additional exploratory scenarios planned by the Fed for next year's stress test or which banks will be included in these scenarios.
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