Decline in bank stress likely to continue as interest rates normalize

Creating more of these models – including multiple benchmarks for an individual loss, expense or revenue component, benchmarks that cover the full range of detailed net income elements, and benchmarks at higher levels of aggregation – would enable more robust assessments of supervisory results both across institutions and over time. Further, growing deviations between benchmark and production projections could highlight emerging (or declining) areas of risk. In this regard, a related area of research could address optimal ways for supervisory to assess the signal when benchmark and production model results deviate significantly from one another. Finally, these simpler models could potentially form the basis of a more dynamic, system-focused stress test analysis that builds in the linkages and feedbacks not currently captured in the CCAR and DFAST stress testing programs. But the walk-through-time approach requires further assumptions, particularly regarding the evolution of the balance sheet.

2. Integrating the 1/3 Rule into Policy and Education

The two funding stresses include a rapid repricing of deposits, combined with a more severe and less severe recession. Under each element, large banks would remain above minimum capital requirements in aggregate, with capital ratio declines of 2.7 percentage points and 1.1 percentage points, respectively. The nearly $685 billion in total projected losses includes $175 billion in credit card losses, $142 billion in losses from commercial and industrial loans, and nearly $80 billion in losses from commercial real estate. In other cases in which the data deficiency is severe enough that a modeled estimate cannot be produced for a portfolio segment or portfolio, the Federal Reserve may assign a conservative rate (e.g., the 10th percentile PPNR rate or the 90th percentile loss rate) to that segment or portfolio. In general, conservative portfolio loss rates are calculated at the most granular definition of a portfolio possible.

2. Blockchain-Based Financial Tracking and Smart Contracts

And even now, though my responsibilities have changed, I remain actively engaged in debates and discussion as the CCAR and DFAST programs evolve, and as the details of stress test modeling and design evolve with those programs. Firms are required to submit detailed loan and securities information for all material portfolios, where portfolios categories are defined in the FR Y-14M and FR Y-14Q instructions. Each firm has the option to either submit or not submit the relevant data schedule for a given portfolio that does not meet the materiality threshold. If the firm does not submit data on its immaterial portfolio(s), the Federal Reserve will assign the median loss rate estimated across the set of firms with material portfolios.

In reviewing the design choices, it’s also helpful to distinguish between choices about what the SCAP, CCAR and DFAST stress tests were designed to capture and how the models measure key elements of the stress test calculations. In particular, the green line in the chart of Indicator 1 reproduces a measure based on inter-dealer repo rates above IORB proposed in Afonso et al. (2024a). This measure is derived from transactions in the cleared tri-party market (GCF), but similar patterns can be seen in comparable measures based on the cleared bilateral market.

8. Global Perspective: Cross-Cultural Analysis with Real-World Data

The Federal Reserve models losses under the net charge-off approach for other consumer loans, business and corporate credit card loans, small-business loans, student loans, and international retail loans. FHLBs, the crucial counterparties for FBOs and LCR banks, can suddenly change their lending behavior and, when reserves are scarce, this change may lead to sudden jumps in the EFFR. If FHLBs anticipate high demand for advances from their members, FHLBs may hold onto cash by withholding lending in the fed funds market on very short notice. The chart of Indicator 1 shows that the proportion of MMF repo lending at rates above IORB has provided an informative early signal of reserve scarcity in the past. As shown by the blue line in the chart, the proportion of MMF repo lending above IORB began increasing in 2018 and reached near 100 percent by early 2019, well before the September repo spike. In contrast, after the expansion of reserves in late 2019, this series dropped to near zero, indicating abundant reserves in the system.

• Since then, the supervisory PPNR models have become considerably more sophisticated, but at their heart, they continue to rely on historical outcomes for revenues and expenses, rather than fully incorporating the fundamental drivers of those outcomes at the business line level.
• Banks with a high ratio of noninterest expense to risk-weighted assets would experience an even larger increase in performance because of the change in model specification.
• In practical terms, the net income approach involves recognizing that banks will have non-credit-related expenses and earn revenues even during periods of stress.
• The two funding stresses include a rapid repricing of deposits, combined with a more severe and less severe recession.

Watch list indicators detect bank stress

I will begin by briefly reviewing how stress testing emerged as a key supervisory policy tool, and talk about how the original goals of the SCAP, CCAR and DFAST stress tests affected modeling and design choices. I’ll then talk about some of the consequences of those choices – in particular, what is missing or not well-captured in the current approach. Finally, I’ll suggest some areas where new research could help push forward the frontier of stress test modeling, both of specific elements that go into the stress test calculation and of the broader impact of the stress testing programs implemented here in the United States and elsewhere. And of course, I need to note that my remarks today are my own and do not necessarily reflect the views of the Federal Reserve Bank of New York or the Federal Reserve System. Our four watch list flags were calculated using publicly available data in the quarterly Call Reports filed by banks. These reports contain bank income statements and balance sheets, detailed loan and deposit information, and they track any asset sales and changes in bank capital.

Indicators draw on quarterly Call Report data

If a given firm reported deficient data for its HELOC portfolio only, then the overall home equity losses for that firm would be based on a conservative loss rate applied to the HELOC portfolio, but HEL projected losses would be modeled using the supervisory model. For the first time, the Board conducted an exploratory market shock on the trading books of the largest banks, testing them against greater inflationary pressures and rising interest rates. This exploratory market shock will not contribute to banks’ capital requirements but was used to further understand the risks with their trading activities and to assess the potential for testing banks against multiple scenarios in the future. The results showed that the largest banks’ trading books were resilient to the rising rate environment tested.

Cost-to-income ratio is calculated by dividing the operating expenses by the operating income generated i.e.net interest income plus the other income. A reserve balances noninterest expenses and bank performance in the stress tests non-interest expense is an operating expense incurred by a bank, and it is separate from the interest expense on customer deposits. It includes the bank’s operating and overhead expenses, such as employee salaries and bonuses, unemployment tax, operating and maintenance of facilities, equipment rental, marketing, insurance, furniture, and amortization of intangibles. The main components of noninterest expense are usually personnel, occupancy, equipment, and professional services. A higher efficiency ratio indicates that the bank faces higher operating costs, which can directly affect the bottom line. When calculating the efficiency ratio of a bank, the numbers needed to compute the ratio are obtained from the bank’s income statement.

Insurance expense is the amount that a company pays to get an insurance contract and any additional premium payments. For personal property leases, a net lease is a lease that requires the customer/lessee to pay for the insurance, maintenance, and all taxes, if any, levied on the equipment. To deduct interest you paid on a debt, review each interest expense to determine how it qualifies and where to take the deduction. For more information, see Publication 535, Business Expenses and Publication 550, Investment Interest and Expenses.

Instead, the Fed could follow industry practice and generate projections for the ratio of noninterest expenses to operating income and use the projected operating income in the stress tests to transform noninterest expenses into dollar amounts. In the last section of the note, we show that this approach would increase the post-stress minimum CET1 capital ratio of the median bank nearly 1 percentage point. Table 2 shows the distribution of the change in the minimum CET1 capital ratio after replacing the noninterest expense projections of BPI’s supervisory model with the efficiency ratio model.

The individual results from the stress test inform a bank’s capital requirements to help ensure a bank could survive a severe recession and financial market shock. Closely related to the scenario horizon question is how cumulative losses and revenues are incorporated to calculate post-stress capital ratios. While the two approaches might be assumed to produce roughly consistent results, the walk-through-time approach may better capture true vulnerabilities, especially in cases where negative net income quarters come early in the stress test horizon but revenues accrue most strongly in subsequent quarters. The instantaneous shock approach implicitly recognizes revenues from later in the horizon as offsets to losses that occur early in the horizon and thus may overstate true capital resources. The tradeoff is that the walk-through-time approach implies a degree of precision about the quarter-by-quarter pattern of losses and revenues that might be beyond the capabilities of existing modeling technology (this was the judgment at the time of the SCAP).

• This year’s hypothetical scenario is tougher than the 2021 test, by design, and includes a severe global recession with substantial stress in commercial real estate and corporate debt markets.
• The Federal Reserve modified the estimate of losses on private equity investments in affordable housing that qualify as Public Welfare Investments (PWI) under Regulation Y. These investments were separately identified and losses were calculated using the market shock that was applied to Section 42 Housing Credits.
• The fourth measure, the adjusted tangible common equity to total assets ratio, has gained prominence since the Fed began raising the fed funds rate in early 2022.
• In this way, they provide additional insight into the true degree of capital adequacy inherent in a bank’s current capital position and the risks embedded in its balance sheet, including its ability to continue to make capital distributions in both baseline and stressed economic conditions.
• They lend cash mostly to foreign banking organizations (FBOs) and to mid-sized to large domestic banks that are subject to the liquidity coverage ratio (LCR).13 The motives behind almost all of these transactions are unrelated to banks’ basic need for liquidity and reserves.

It remained near zero for most of 2024, as reserves declined modestly while the Federal Reserve’s balance sheet shrank considerably. A sharp jump in the share of banks flagged for low adjusted tangible common equity ratios drove the overall increase in bank risk from 2022 onward. This jump reflects the steep rise in interest rates in 2022, which slashed the market value of securities accumulated during the pandemic when banks were flush with cash. The mark-to-market losses significantly reduced the adjusted tangible common equity ratios of banks with large securities holdings. The Board’s stress test is one tool to help ensure that large banks can support the economy during downturns. The test evaluates the resilience of large banks by estimating their capital levels, losses, revenue and expenses under a single hypothetical recession and financial market shock, using banks’ data as of the end of last year.

The individual bank results from the stress test will factor directly into a bank’s capital requirements, mandating each bank to hold enough capital to survive a severe recession. On the other hand, commercial banks mainly focus on holding customer deposits and creating loans to potential borrowers, which does not require the same level of employee involvement and compensation compared to investment banks. Since non-interest expenses are a major component of a bank’s overall expenses, they are considered bank overheads and are used to calculate the overhead ratio. The main components of noninterest income are fees such as deposit service charges, funds transfer fees, trust fees, brokerage fees, etc.

Bank stress has steadily declined since a series of bank failures in the spring of 2023, based on a review using four key measures common to the bank examination process. Stress rose significantly during the pandemic and again in 2022, when the Federal Reserve began raising interest rates to curb inflation. Under the two trading book stresses, which included the failure of five large hedge funds under different market conditions, the largest and most complex banks are projected to lose between $70 billion and $85 billion. The results demonstrated that these banks have material exposure to hedge funds but that they can withstand different types of trading book shocks. The Board also conducted an exploratory analysis, including two funding stresses to all banks tested and two trading book stresses to only the largest and most complex banks.

Consistent with the Board’s Stress Testing Policy Statement, the Federal Reserve makes certain assumptions about missing data or data with deficiencies significant enough to preclude the use of supervisory models. Given a reasonable set of assumptions or approaches, all else equal, the Federal Reserve will opt to use those that result in larger losses or lower revenue. The Federal Reserve Board on Wednesday released the results of its annual bank stress test, which demonstrates that large banks are well positioned to weather a severe recession and continue to lend to households and businesses even during a severe recession. “Over the past year, the Federal Reserve has run three stress tests with several different hypothetical recessions and all have confirmed that the banking system is strongly positioned to support the ongoing recovery,” said Vice Chair for Supervision Randal K. Quarles. In theory, an optimal efficiency ratio is 50 percent, but banks regularly end up with higher numbers. A non-interest bearing current liability is an item in a corporate balance sheet that reflects short-term expenses and debts that are not accruing interest.

The Federal Reserve modified the estimate of losses on private equity investments in affordable housing that qualify as Public Welfare Investments (PWI) under Regulation Y. These investments were separately identified and losses were calculated using the market shock that was applied to Section 42 Housing Credits. The Federal Reserve collected additional information to refine its approach to identifying these investments and estimating their losses. The Federal Reserve separately models losses from operational risk and other real-estate-owned (OREO) expenses. Operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events.”23 OREO expenses are those expenses related to the disposition of real-estate-owned properties and stem from losses on first-lien mortgages.

We see a similar rise and subsequent decline locally and nationally in the percentage exposure to our watch list flags during the pandemic period, as well as much higher exposure around the onset of higher interest rates and the banking crisis (Chart 5). Asset growth was the main driver of potential bank stress during the pandemic, as consumers deposited government relief funds at banks (Chart 4). Nearly 19 percent of banks in our sample grew total assets by more than 35 percent between the fourth quarter of 2019 and the fourth quarter of 2020. The largest counterparty default scenario component is applied to firms with substantial trading or custodial operations. The LCPD captures the risk of losses due to an unexpected default of the counterparty whose default on all derivatives and SFTs would generate the largest stressed losses for a firm. As narrowly defined, a natural hedge is one in which the rate risk in one piece of customer business is offset by the rate risk in another piece of customer business.