How do bank stress-tests work?

February 9, 2017

This would be a very high-level simplification of what in reality is an incredibly complex exercise involving risk modeling experts and quants.

Banking “stress tests” are usually presented to the bank by regulators as a macroeconomic scenario (i.e.: unemployment rate increases, inflation decreases, etc.) which must then be converted to financial “risk factors” that impact the bank in some way.

“Risk factors” are key factors that are likely to cause volatility (unexpected changes) in the value of some asset or asset group of the bank’s, impacting its value or performance. For instance, in an equity investment, the risk factor would be the volatility of the stock price. For loans, it might be the probability of default of a corporation.

In order to translate the impact of this macroeconomic scenario, banks sometimes use factor models. These models are often based on historical statistical relationships, although a degree of judgement is often exercised, and attempt to map the sensitivity of risk factors to macroeconomic variables.

Once the risk factors have been adjusted by the factor models, a separate group of models are then run with these new risk factor values as inputs, and the bank can then generate stressed financial statements (stressed balance sheet and stressed income statement) to assess the financial impact of the scenario.

By Bruce Haydon

Banks And Deregulation

December 31, 2016

By Bruce Haydon


So why aren’t the big banks cheering at the prospect of repealing the Dodd-Frank Act?

Banks Resist Wholesale Deregulation copyright Bruce Haydon 2016Given how loudly these big banks have complained about burdensome regulatory obligations put in place after 2008, it would be perfectly reasonable to assume they would be ecstatic with the prospect of the incoming government dismantling Dodd-Frank.  In actuality, they appear lukewarm at best.

The Republicans, led by Rep. Jeb Hensarling,  are pushing hard for a full replacement of the Dodd-Frank Act, legislation that was put into place by the Obama administration in 2010.

Bank stocks are direct benefactors of this new wind blowing through Wall Street, having gained roughly 20% since the election.  However, some of the large banks appear lukewarm to wholesale change, and instead prefer existing regulations be simplified and less burdensome.

So why would banks oppose being fully unshackled from burdensome regulations? Primarily because they have invested a staggering amount of resources constructing a complex governance infrastructure to support the existing regulatory framework. To have to dismantle it and start at ground zero again with an entirely different set of rules would exact an enormous cost. In this low-interest rate environment where banks’ ability to generate income is severely handicapped, keeping expenses down is paramount.

There is also a fear amongst banks that influential voices in the new administration are advocating higher capital requirements as a trade-off for easing up on regulations. Capital represents funds generated through shareholder purchases of the bank’s shares (equity), which are kept on the balance sheet as a buffer against losses. The downside of keeping capital reserves stockpiled in this manner is its potential to diminish a bank’s profitability.

It’s commonly agreed that before the 2008 crisis, banks did not carry enough capital to offset their excessive borrowing, leaving them vulnerable. Those critical of today’s regulations feel the new mandated levels of capital are set too high, stifling banks’ ability to earn revenue by lending.

Under current regulations, banks are forced to meet a number of different capital requirements, including one known as the “leverage ratio”. This metric represents equity as a fraction of total assets. By acting as a drag on a bank’s ability to borrow, the “leverage ratio” attempts to reduce its chance of failing.

Following the 2008 crisis, regulators stipulated the large banks maintain a leverage ratio of 5%. There are a number of conservative voices (including Mr. Hensarling) calling for the leverage ratio to be increased to 10%, with some even advocating as high as 20%, as a quid pro quo for easing the regulatory burden. One industry analyst estimates the extra equity required to meet a new leverage ratio of 10% would reduce a bank’s average return on capital by 5%.

But there’s another reason existing banks are lukewarm to wholesale repeal. They are keenly aware that the punishing compliance costs and capital requirements of Dodd-Frank create high barriers to entry for any new competitors. With the myriad of small FinTech startups like QuickLoans, Square and Lending Club nipping at their heels for the lucrative retail banking business, nobody on Wall Street is in any rush to lower the drawbridge.

So have these higher barriers to entry really made our financial world safer? During the 2008 Banking Crisis, many of the today’s large banks were deemed “too big to fail” (now known as Systemically Important Financial Institutions, or “SIFI’s”). With these new structural barriers to market entry, it follows that risk cannot be distributed over a larger number of institutions, so it continues highly concentrated amongst the few existing key players.

So between the interests of the large banks and regulators, it’s not likely the industry is going to be pushing for wholesale deregulation anytime soon.

© Copyright Bruce Haydon 2017




Financial Frontiers

March 5, 2010