Federal Reserve Hints That Maybe Banks Should Hire Jerry Bruckheimer To Help Write Their Stress Test Scenarios

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Today the Fed released a paper making fun of banks for their lame responses to the Fed's stress tests, both on prudential-regulatory and on literary grounds. For instance, the banks were supposed to come up with their own stress scenario and see how they'd do in that scenario, and a lot of banks apparently phoned in that effort. The Fed was unimpressed:

A BHC [bank holding company] stress scenario that simply features a generic weakening of macroeconomic conditions similar in magnitude to the supervisory severely adverse scenario does not meet [the Fed's] expectations.

BHCs with stronger scenario-design practices clearly and creatively tailored their BHC stress scenarios to their unique business-model features, emphasizing important sources of risk not captured in the supervisory severely adverse scenario. Examples of such risks observed in practice included a significant counterparty default; a natural disaster or other operational-risk event; and a more acute stress on a particular region, industry, and/or asset class as compared to the stress applied to general macroeconomic conditions in the supervisory adverse and severely adverse scenarios.

At the same time, BHC stress scenarios should not feature assumptions that specifically benefit the BHC. For example, some BHCs with weaker scenario-design practices assumed that they would be viewed as strong compared to their competitors in a stress scenario and would therefore experience increased market share.

Oh sure you get points for, I don't know, having a lot of capital or whatever the ultimate point of all of this is, but what really distinguishes a B+ from an A bank, stress-test-wise, is creative scenario design. Natural disasters! "Operational-risk events"! (Which is a bloodless term for your accountant/rogue trader running away with all of your money.) Top marks went to banks who kept things exciting and really let their creative juices flow, though I think we can all agree that a stress scenario of "all the other banks will disappear and we will be the best bank and have all the money" is a little too creative.

This report is - well, one, it's boring, let's get that out of the way, it's really quite boring, it's a report on bank capital planning that omits (1) numbers and (2) any names of banks, so there's a lot of pretty vague rumbling about How To Be A Good Bank.1 You could understand the banks being a bit annoyed by it; here is a horrifying paragraph:

The Fed also spelled out more explicitly than it has done previously its expectation that the largest and most complex banks will hold more than the bare minimum of capital as a buffer against potential losses. Regulators want banks to set capital targets above even their own internal capital goals, an unofficial requirement that could drive some banks to further raise capital levels.

I mean: if the regulator requires you to hold an amount of capital X, then X cannot be "more than the bare minimum of capital." X has become your "bare minimum" of capital. If you set a capital target above your capital goals, then your capital goals are now your capital target, or vice versa, if you see what I mean, and I guess there's no particular reason why you would. The point is: you have to have as much capital as your regulator tells you to. If it tells you to have more, you gotta have more. If it tells you to have more with forty pages of tongue-clucking and insinuation and calls for creativity, then that is annoying. Why don't you just tell me the name of the movie you'd like to see?

But, I don't know, read it for a while - not recommended! - and it starts to feel weirdly persuasive. Human nature and asymmetric incentives mean that creativity in banking is skewed to the upside; it's more fun to think up outlandish ways to make money than outlandish ways you might lose it. When JPMorgan did its stress tests in 2011, did its scenario designers include "a rogue whale wanders into our London office, passes himself off as a credit derivatives trader, rises to a position of prominence, and then loses six billion dollars while his boss and underling work tirelessly to cover it up" among its stress scenarios? Maybe! But, no. That tidbit about banks assuming they'd gain market shares in stress scenarios seems meaningful: even when you give a bank an assignment like "think up some disaster scenarios" they somehow spin it optimistically.

In lieu of reading the Fed report you could just do a search on the word "weaker":

BHCs with weaker documentation practices had board minutes that were very brief and opaque, with little reference to information used by the board to make its decisions. Some BHCs did not formally document key decisions. ...

BHCs with weaker practices often had limited documentation [of model estimation practices] that was poorly organized and that relied heavily on subjective management judgment for key model inputs with limited empirical support for and documentation of these adjustments. ...

BHCs with weaker practices used models with low predictive power, in part due to data limitations. ... BHCs with weaker practices relied on models that were overly influenced by limited data covering a single economic cycle. ...

Some BHCs with weaker practices made business model and strategy assumptions (e.g., new business, expense reductions, the assumption of mitigating actions) that were not consistent with stressed scenario conditions and the intent of a capital planning and stress testing exercise. For example, management assumed it would be able to drastically reduce loan origination activity, cut expenses, or take other mitigating actions in a severely adverse scenario without considering the longer-term consequences on the BHC’s strategy and operating structure. ...

It goes on.2 Those things sound bad! It probably is the case that some banks are better managed than others, and that the, um, others tend to do things like rely blithely on "subjective management judgment" rather than on objective facts and comprehensive data or even board oversight. And the Fed's job is not primarily to (1) set an ideal capital ratio and (2) make sure that banks have at least that much capital. It's to, like, make sure the banks don't fail and stuff. Capital ratios are an important tool in that effort, but good management is probably more important.3 And mandating, regulating for, or even identifying good management is hard. Still it's probably worth the effort for a banking regulator to identify examples of bad management. And then try to make fun of them until they change their ways.

Capital Planning at Large Bank Holding Companies: Supervisory Expectations and Range of Current Practice [Fed]
Fed Boosts Pressure on Banks Over Capital Levels [WSJ]
Banks Not Tough Enough on Themselves in Stress Tests, Fed Says [DealBook]
Whose overconfident banks are these? [FTAV]

1.Also any calls for creativity, in the banking context, always give me heebie-jeebies. It's too reminiscent of conversations like this at my old job:

Banker: We have a client with a billion dollars in debt, a $50 million market cap, and large net losses for each of the last five years, and they would like to raise a billion dollars to pay a special dividend. Now, they can't afford to pay any interest, and they don't want to dilute the equity. Is there some product we can offer them to achieve their objectives?
Me: No.
Banker: Well, let's be creative here. If we come to them with a really good idea, this business is ours.
Me: Gaaaaaaaaaaaaaaaaaarghhhhhh.
Banker: Maybe some sort of derivative?
Me: [Mutes phone, curses]
Banker: Try to think outside the box.
Me: One day I will blog about this you know.

2.It got boring up there so here are some more:

BHCs with weaker practices in this area did not clearly link decisions regarding capital distributions to capital adequacy metrics or internal capital goals. ...

BHCs with weaker practices failed to compensate for data limitations or adequately demonstrate that external data reasonably reflect the BHC’s actual exposures, often failing to capture geographic, industry, or lending-type concentrations. ...

BHCs with weaker practices used a single model for multiple portfolios, without sufficiently adjusting modeling assumptions to capture the unique risk drivers of each portfolio. For example, in estimating losses on wholesale portfolios, these BHCs did not adequately allow for variation in loss rates commonly attributed to industry, obligor type, collateral, lien position, or other relevant information. ...

BHCs with weaker practices did not project stressed exposures associated with undrawn commitments and/or relied on the assumption that they can actively manage down committed lines during stress scenarios. ...

However, some BHCs with weaker practice used a ratings-based approach [for impairment of AFS and HTM securities] that kept the ratings static over the scenario horizon. ...

Still not comprehensive but it got boring down here too.

3.That's the sort of sententious and worthy thing you're supposed to say in the last paragraph of a post but I don't know if it's true. Is it? I have a strong bias toward the model of banks being a squirming pile of stochastic variables that no one can completely manage and to which you can only really take a probabilistic approach. Which would perhaps argue for the model of "just chuck a big haircut on it," i.e. capital being more important than management. But on the other hand some people/approaches definitely are better at managing squirming piles of stochastic variables than other people/approaches are, and the differences probably are significant. I dunno, thoughts?

Related

Citi Will Try The Stress Test Again With A $9bn Stock Buyback

More stress tests, bleargh. I guess the news is that Citi "failed", though I can't get all that excited by that because it didn't exactly "fail" in the sense of now it's being forced to raise capital / broken up / burned to the ground. Instead it failed assuming it follows the capital plan it submitted to the Fed, which is clearly a capital-lowering rather than capital-raising plan. I ballpark it at $10bn of share repurchases and dividends,* which is ... well, it's pretty big for Citi. So they can just not do that then. Or not do quite as much of that, which seems to be their plan: In light of the Federal Reserve’s actions, Citi will submit a revised Capital Plan to the Federal Reserve later this year, as required by the applicable regulations. The Federal Reserve advised Citi that it has no objection to our continuing the existing dividend levels on our preferred stock and our common stock, and we plan to do so, subject to approval by the Board of Directors each quarter. The Federal Reserve also advised that it has no objection to Citi redeeming certain series of outstanding trust preferred securities, as Citi proposed in its Capital Plan. We plan to engage further with the Federal Reserve to understand their new stress loss models. We strongly encourage the public release of these models and the associated benchmarks and assumptions. We believe greater transparency in this process will best serve all banking institutions and their shareholders as well as the international regulatory community and market participants, and will encourage a level playing field globally. There are at least two ha! moments in that snotty last paragraph. First there's the fact that the Fed had planned to release the stress test results on Thursday and got gun-jumped by Jamie Dimon. So much for Fed transparency. But also, specifically, as people are all running around suing each other about the Fed maybe kind of encouraging bank CEOs to hide material information from investors, it is odd that the Fed would have the stress test results and sit on them for two days. Imagine the scenario where Jamie Dimon, Vikram Pandit, and the Fed all know that JPM passed and was going to do a largeish buyback, while Citi failed and was going to do a ... I guess somewhat smaller buyback - and they didn't tell anyone from today until Thursday. If you sold JPM to buy C today, wouldn't you be kind of annoyed?**