Post-Mortem on the 2023 Stress Tests Results

admin Jul 04, 2023

In this post, we make some observations about the stress test results recently released by the Federal Reserve, highlighting significant limitations of these supervisory projections. These limitations contribute to excessive volatility in bank-level results, leading to increased instability in banks’ capital requirements and hindering their capacity to efficiently manage their capital on a year-over-year basis.

In the current stress capital buffer framework, a bank’s performance in the stress tests directly affects its ongoing capital requirement. Therefore, the Federal Reserve needs to be significantly more transparent about how it projects stress losses and revenues for banks. This transparency enables banks to make informed and efficient decisions on their balance sheets and capital that consider supervisors’ views of risks.

Furthermore, a significant overhaul is needed in the way the Federal Reserve generates projections of pre-provision net revenue (PPNR). The current approach, which heavily relies on a bank’s recent performance to determine its performance in stress tests under the severely adverse scenario, undermines the reliability of the results. Moreover, a more robust methodology should be implemented in the projections of certain components of regulatory capital. This would better capture the complexities and unique risk profiles of individual banks, such as the effect of interest rates on unrealized gains and losses on investment securities.

Overview of the 2023 Stress Results

The stress test scenario for this year was designed to be more severe, featuring a greater increase in the unemployment rate and a larger, faster decline in house prices. In addition, the scenario continued to assume a significant drop in commercial real estate prices. As a result of these more challenging conditions, the expected losses for the same set of banks increased by $43 billion or 11 percent compared with last year’s stress test results.

Apart from the scenario’s severity, another crucial factor influencing banks’ performance in the stress tests is the PPNR projections. While the aggregate level projections remained relatively unchanged from 2022, there were notable differences among the various cohorts of banks because the Fed’s projections include large momentum effects. Last year, banks’ net interest income rose as rising rates pushed up yields on assets faster than on liabilities. As a result, the Fed projected that the PPNR of banks with substantial interest income would go up. Conversely, last year, banks experienced a decline in fee income primarily due to a slowdown in investment banking and certain other fee income businesses, such as mortgage refinancing, amidst the rising interest rate environment. The Fed then projected the PPNR of banks with substantial fee revenue would go down. Note that, in both cases, the projections seem to largely ignore that interest rates are assumed to fall in the scenario. Meanwhile, for subsidiaries of foreign banks operating in the U.S. (through intermediate holding companies), the Fed projected significant declines in PPNR, mainly attributed to model updates, which we will discuss in more detail.

Another major driver of improved performance observed in the stress tests was the decrease in unrealized losses on investment securities for the largest banks, which are not subject to the accumulated other comprehensive income (AOCI) filter. In 2022, as interest rates increased, many banks began the stress tests with substantial unrealized losses on their investment securities. Because of the increase in interest rates last year, 2023’s scenario involved a more significant decline in interest rates compared with the previous year, which typically happens in a severe recession. The decline in interest rates in the stress scenario resulted in the largest banks collectively experiencing a notable increase of $57 billion in unrealized gains on their investment securities.

In addition to the reduction in unrealized losses, this year’s stress tests also showed slightly lower losses associated with the global market shock. There was also a 50-percent reduction in other losses, which encompasses changes in the fair value of loans held for sale.

In summary, the stress tests project a maximum decline in the common equity tier 1 (CET1) capital ratio of 2.3 percentage points, a decline about 40 basis points lower than last year’s. These findings highlight the impact of the more severe stress test scenario, the variations in PPNR projections among different bank groups, the reduction in unrealized losses on investment securities, and the lower losses associated with the global market shock and other factors.

Excessive Volatility in Bank-Level Results Remains a Distinctive Feature of Stress Tests

Excessive volatility in bank-level results within supervisory stress tests has become a significant concern among banks. One main reason for excessive volatility is the inherent limitations of the supervisory projections used in stress tests. These projections rely heavily on aggregated models that may not fully capture the intricacies and specific risk profiles of individual banks. As a result, bank-level results can fluctuate dramatically, leading to significant variations in capital requirements from year to year.

The impact of excessive volatility extends beyond mere fluctuations in capital requirements. When bank-level results are highly volatile, financial institutions find it difficult to accurately plan and allocate capital resources. This uncertainty can hinder long-term strategic decision-making, impair capital deployment strategies, and limit the pursuit of growth opportunities.

In a comprehensive view of the changes in bank-specific stress test results, Exhibit 1 illustrates the variations in stress test outcomes for each participating bank between the 2023 stress tests and 2022’s results. The banks are ranked—that is, ordered from left to right—from best to worst relative performance, based on the projected decline in their CET1 capital ratios. The bank positioned on the far left shows the most substantial improvement in CET1 drawdown compared with the previous year’s stress test, while the bank on the far right represents the worst deterioration in projected performance.

Notably, about half of the banks that participated in this year’s stress tests had performance changes exceeding 1 percentage point in absolute value. Moreover, two banks shown on the right-hand side of Exhibit 1 demonstrated an increase in their capital requirement of 4.8 and 5.8 percentage points, respectively. This highlights the magnitude of changes observed in the capital requirements of certain banks, underscoring the significant impact of the stress test results.

Critically, most of these changes in capital requirements were not being driven by shifts in the risk of the banks’ balance sheets or business models, nor meaningfully by changes in economic outlook. These massive changes in the banks’ capital requirements are the result of quirks of or adjustments to the non-disclosed models the Fed uses to project the banks’ performance.

Exhibit 2 reveals that, compared with the stress test results of the past decade, this year’s outcomes were unique, primarily because of the presence of two outlier banks. But even after accounting for these outliers, overall, the level of volatility in bank-level stress test remained elevated and not too different from the average of the prior 10 years.

It is worth noting that, on average, we observed a slightly higher proportion of banks with improved performance relative to the results of the previous year. This improvement can be attributed, at least partly, to a smaller decline in the aggregate capital ratio. One contributing factor would be the unrealized gains on banks’ investment securities.

In the rest of this post, we present more details about some of the factors driving the excess volatility in bank-stress test results, based on the limited information publicly available.