Higher capital is not a substitute for stress tests

Stress testing large banks was one of the key innovations in financial regulation that followed the financial crisis.  Since the crisis, stress tests have evolved from a crisis-management tool to a supervisory function to help prevent another financial crisis by ensuring banks pre-emptively build capital for severe economic conditions.  The Dodd-Frank Act of 2010 made supervisory stress tests mandatory for systemically important financial institutions.

Concerns that stress tests are expensive to implement have led to a proposal to eliminate or reduce the frequency of stress tests if bank holding companies meet higher capital requirements.  However, higher capital requirements on their own would not provide many of the significant benefits of current stress testing practices.

Microprudential benefits:

  • Stress tests provide incentives to banks to invest in rigorous data and risk management practices, and forward-looking “what if” scenarios, not just “most likely” scenarios.
  • Standardized scenarios for stress tests make risk disclosures more comparable and enhance market discipline.

Macroprudential benefits:

  • Stress tests support the economy, not just the strength of individual institutions, by helping to ensure banks have sufficient capital to continue to lend in an economic downturn.
  • Forward-looking capital requirements in stress tests offset pro-cyclical tendencies of static capital requirements.

Steps can and should be taken to reduce the burden of stress tests. The number of BHCs and banks that have mandatory stress tests could be reduced. The stress test program could be simplified by relaxing the supervisors’ assumption that all of a firm’s planned dividends and repurchases would proceed through the two-year planning horizon, implementing a stress capital buffer, eliminating the soft constraint on dividends of 30 percent of expected earnings, simplifying models of the balance sheet, and improving countercyclicality.