Navigating Economic Uncertainty with Financial Stress Testing
The economy is experiencing a fragile recovery from the ongoing COVID-19 pandemic. Despite the $2.2 trillion fiscal stimulus (CARES Act) passed in March, there is a growing sense that the recovery is losing steam. The uncertainties around the likelihood of Congress passing an additional relief bill, the upcoming U.S. election results, and further waves of COVID-19 and re-opening timelines creates added challenges for an organization to plan their capital and strategy.
For the first time since the 2008 financial crisis, all of this market uncertainty has challenged the effectiveness and robustness of the Comprehensive Capital Analysis and Review (CCAR)/ Dodd-Frank Act Stress Tests (DFAST) regulatory program.
This pandemic provides an opportunity for financial institutions to obtain real-time feedback on the models’ performance against an actual economic downturn. A common observation among banks who are required to be CCAR/ DFAST/ Current Expected Credit Losses (CECL) compliant is that their models’ loss projections were more severe than those experienced in the current market. Model overlays were used to remediate to this difference, but there have been key takeaways from this exercise.
Here are three key observations and recommendations that financial institutions can consider when refining their stress testing model and process:
Correlations of External Drivers
Through statistical techniques, the correlation of external drivers (e.g., macroeconomic factors or government regulations) with an organization’s key business drivers that impact their balance sheet and income statement is developed. During COVID-19, several external drivers such as global shutdown, fiscal policy and monetary policy support have altered these correlations. For example, most of the current models associate several key macroeconomic variables such as real GDP, unemployment rate, and disposable personal income as indicators of an individual and organization’s income. It assumes that once these macroeconomic variables turn unfavorable, it is an indication that an individual or organization’s financial health will be reduced, which impacts their ability to meet their loan obligations. This will result in an increase of loan defaults.
In the first half of the year, major U.S. banks set aside the largest loan loss provisions amount since the 2008 financial crisis. Under normal circumstances, banks should have experienced a significant increase in corporate and personal loan defaults. However, the economic stimulus packages have replaced household income through an increase in unemployment benefits and stimulus checks to each member of a household. This allowed most individuals to continue fulfilling their mortgage, credit card and personal loan obligations. In addition, relief packages to small and large businesses have kept organizations afloat despite the reduction of economic activities, which resulted in negative quarter-to-quarter real GDP. Consequently, revisiting the scenario narratives and correlation of external to key business drivers based on the current economic conditions would help in a more meaningful stress loss projection and reduce the number of model overlays.
Granularity of Shock Variables
Every major financial institution has an economist team to research, analyze, and monitor the economic data, and develop an economic forecast. However, is their current model adequately designed to incorporate the forecasts collected by the economist? As model parameters require time to be developed or updated, financial institutions should plan ahead and set up the model environment to allow their exposures to be stressed at a granular shock level, which will enable a more accurate stress loss result to be derived.
In this pandemic, the Federal Reserve Board’s credit facility program has components that will only benefit a subset of financial products and counterparties. For example, the Corporate Credit Facility program provides credit to companies by purchasing investment-grade bonds issued by U.S corporations, which reduced the default risk as compared to all other non-investment and non-U.S. corporations investment-grade bonds. Additionally, corporations/ counterparties in countries with strong government support or who are in the advanced stage of fully re-opening the economy would also be considered less likely to default. The model parameters at a granular level should factor in these details to reduce ambiguity and ascertain the risk more accurately. These will help senior management of the financial institution to better understand and manage the firm’s risks.
Simplified Scenario Design and Stress Testing Policy and Procedures
Scenario design is an extensive process which undergoes multiple iterations before it is finalized. During this pandemic, the timeliness of the scenario design process has been called into question. The Federal Reserve Board (FRB) and Bank Holding Company (BHC) scenario shocks used in May for the full revaluation calculation of the CCAR/ DFAST submission did not consider the impact from the pandemic. As a result, the stress testing results were less meaningful, which may have prompted the FRB – for the first time since the inception of the CCAR program – to request a CCAR re-submission from all participants. Based on the new FRB scenarios released in September, financial institutions are currently completing their CCAR resubmission production cycle.
There is always a trade-off between timeliness and accuracy. From this pandemic, we have learned that a financial institution should maintain a simplified scenario design and stress testing policy and procedures that can be triggered after the occurrence of a certain event (e.g., S&P 500 index dropping by 25 percent in a week). By taking into considerations current economic developments, this allows financial institutions to shift to a more simplified procedure to update the scenario narratives. All teams involved in this simplified process should understand their modified responsibilities and be able to complete their tasks in the stipulated timing. Internal Audit should be involved in the design of this streamlined governance framework in order to ensure that the process can be executed on a timely basis, but within acceptable risk tolerance levels, to ensure integrity of the results. This will allow financial institutions to have a suitable view of their risks and financial health to make the informed business decisions.
Because this crisis is unlike anything previous, the economy is going through uncharted territory. An effective scenario design, stress testing model, and process provides an early warning to organizations about how various scenarios could play out. By providing sound guidelines and evaluating the economic impact from a broad range of scenarios, this allows organizations to make swift and more informed decisions. To successfully navigate through this pandemic, organizations should:
- Revisit their scenario narratives and correlations between external drivers and key business drivers that impact the balance sheet and income statement;
- Increase the granularity of shock variables to factor in details that have high impact to specific firm exposures; and
- Set up a simplified scenario design and stress testing policy and procedures to incorporate the current economic developments or forecasts on a timely basis.
These steps will enable organizations to manage their risks more effectively and position them for success when the economy improves.
For more, our guidebook provides leaders with a roadmap to enhance resiliency plans, simplify operations, address new financial requirements, and more. To download, please click the link below.