Understanding the effects of the US stress tests

U.S. flags hang at the New York Stock Exchange in Manhattan, New York City, U.S., December 21, 2016. REUTERS/Andrew Kelly - RC166FFF9250
Editor's note:

The paper was presented at  a Federal Reserve conference on stress testing held July 9, 2019, at the Federal Reserve Bank of Boston. 

Concurrent stress tests—testing all major banks with the same macroeconomic and market scenarios at the same time—were a key innovation growing out of the financial crisis of 2007-09. Their original intent in 2009 was to identify the capital needed by banks to continue functioning in a deep recession and require them to raise the capital, from private sources or the government, to support the economy. The stress tests have evolved considerably since 2009, but the underlying rationale remains to assure that major banks can continue to supply credit to households and businesses in circumstances of deep economic and financial distress. The tests allow policymakers to assess the adequacy of capital buffers and to require remediation when necessary through modifications to institutions’ capital plans. They are a strong microprudential tool, with important macroprudential elements.

In this paper, Donald Kohn and Nellie Liang of the Hutchins Center on Fiscal and Monetary Policy at Brookings focused on assessing some of the effects of this new prudential tool as implemented in the United States, and contributing to the Federal Reserve Board’s review of its supervisory stress tests. They analyzed the data that are publicly disclosed about the stress tests for their implications for bank capital requirements and risk management, and marshaled the evidence from existing studies on the effects of stress tests on credit rather than undertaking new efforts. In addition, they interviewed a number of people knowledgeable about the stress tests to get their views on their effects. These included current and former supervisors and Federal Reserve economists (some of whom are now at consultancies advising banks on stress tests or at interest groups), current and former bankers involved in the stress tests at the banks, and other interested observers.

Kohn and Liang focused on looking at the evidence on the following three questions about stress test effects:

  1. Have the stress tests helped to counter potential procyclicality of bank capital?
  2. Have the stress tests improved risk management and capital planning at tested institutions?
  3. Have the stress tests affected the cost and availability of credit from the largest banks?

Read the full paper here»