Thus a hedge involving the investment portfolio is not a natural hedge under the most narrow definition of the term. If the efficiency ratio increases, it means a bank’s expenses are increasing or its revenues are decreasing. We look at changes in our four watch list indicators from the first quarter of 2019 to the fourth quarter of 2024, the latest quarter for which we have Call Report data. In line with standard practice, we confine our analysis to national and state member banks, state savings banks, federal savings banks and savings and loan associations. Second, many bank customers switched to money market funds that paid higher interest rates, resulting in large deposit outflows at banks. These developments set the stage for widespread banking stress and three major regional bank failures in spring 2023 (Silicon Valley Bank, Signature Bank and First Republic Bank).
4. Implementation Challenges in Diverse Economic Environments
Measures of inter-dealer transactions are valuable for analyzing a wide variety of issues that impact dealers’ repo market activities.17 Our indicator builds on the insights of these existing measures by helping to isolate the effect of reserve scarcity from other factors affecting inter-dealer rates. Since MMFs do not serve as intermediaries in repo markets, the rates they are willing to accept are affected only indirectly by constraints on dealer intermediation such as balance sheet costs, which have more substantial impacts on inter-dealer rates. And because repo is simply a means for MMFs to invest cash, the rates they accept do not reflect demand for specific securities as collateral, which affects cash-lending rates received by dealers and hedge funds. Repo lending by MMFs provides cash to dealers, which enables dealers to finance their securities portfolios and extend funds to leveraged entities such as hedge funds.
2. Integrating the 1/3 Rule into Policy and Education
Over time, supervisory estimates have become increasingly independent from the projections made by banks. This was a policy choice intended to provide consistency of treatment across banks involved in the stress tests and to counteract any incentives banks might have to understate the impact of the stress scenario. Bank-specific elements – which, as noted above, are critical to the microprudential policy objectives of the CCAR and DFAST programs – are introduced by using detailed data provided by each participating institution.
The trading and private equity model generates loss estimates related to trading and private equity positions under the global market shock. In addition, the global market shock is applied to firm counterparty exposures to generate losses due to changes reserve balances noninterest expenses and bank performance in the stress tests in CVA. The individual results from the stress test factor directly into a bank’s capital requirements, mandating each bank to hold enough capital to survive a severe recession and financial market shock. If a bank does not stay above its capital requirements, it is subject to automatic restrictions on capital distributions and discretionary bonus payments. “Today’s results confirm that the banking system remains strong and resilient,” Vice Chair for Supervision Michael S. Barr said. “At the same time, this stress test is only one way to measure that strength. We should remain humble about how risks can arise and continue our work to ensure that banks are resilient to a range of economic scenarios, market shocks, and other stresses.”
The models used in the CCAR and DFAST supervisory stress tests are developed and implemented by supervisors – they are almost entirely independent of stress test models used by banks. The SCAP results were based on a variety of sources, including projections made by the banks, simple supervisory models, and historical data on bank performance. The blending of sources reflected that the SCAP was the first broad-based supervisory stress testing program, conducted in a crisis environment, with significant learning along the way. The Federal Reserve estimates the effect of supervisory scenarios on the regulatory capital ratios of firms participating in the supervisory stress test by projecting net income and other components of regulatory capital for each firm over a nine-quarter projection horizon.
- A non-interest expense is an operating expense incurred by a bank, and it is separate from the interest expense on customer deposits.
- To begin, capital ratios are measured separately for individual institutions, with no attempt to capture dynamic interactions, spillovers or specific cross-firm exposures.
- In addition, the Federal Reserve re-estimated its full suite of PPNR models on an expanded sample, re-specifying models based on performance testing.
- Repo lending by MMFs provides cash to dealers, which enables dealers to finance their securities portfolios and extend funds to leveraged entities such as hedge funds.
Appendix A.1.5. Step 5: Risk Adjustment Terms
Many banks were surprised when the Fed increased rates by more than 5 percentage points between February 2022 and July 2023. The market value of debt issues such as Treasuries and mortgage-backed securities moves inversely to interest rates; higher interest rates reduce the market value of outstanding debt. These losses in most cases are not reflected in standard regulatory capital measures but are captured by the adjusted tangible common equity ratio. All 31 banks tested remained above their minimum common equity tier 1 (CET1) capital requirements during the hypothetical recession, after absorbing total projected hypothetical losses of nearly $685 billion.
As already noted, the CCAR/DFAST stress tests do not incorporate cross-bank exposures in a dynamic way, nor is there feedback between the outcomes for the banking sector and the macroeconomic scenario. The fair value of securities in the AFS portfolio may change in response to the macroeconomic scenarios. FHLBs may continue to lend at the same rates despite rising repo rates and forego a higher-yielding investment in return for stability because their counterparties are highly rate sensitive.30 Lending at stale rates may cause a disconnect between the rates in the repo and funds markets.
Funding
The median bank in our sample would experience an 86-basis-point increase in its post-stress CET1 ratio, which represents a material improvement in performance. Banks with a high ratio of noninterest expense to risk-weighted assets would experience an even larger increase in performance because of the change in model specification. ” is to note that the SCAP, CCAR and DFAST programs are by design capital stress tests and do not directly assess other areas of institutional or financial sector vulnerability, such as liquidity, funding or firesale risks. The current supervisory stress testing regime does address these risks indirectly, to the extent that a banking sector with more robust capitalization is less likely to experience liquidity stresses, runs and the resulting firesales. And, through the Federal Reserve’s Supervisory Liquidity Analysis and Review (CLAR) program, large complex banking companies are subject to separate supervisory stress testing of their liquidity resources.
The tests evaluate the resilience of large banks by estimating their losses, revenue, and capital levels—which provide a cushion against losses—under hypothetical scenarios over nine future quarters. This year’s hypothetical scenario is tougher than the 2021 test, by design, and includes a severe global recession with substantial stress in commercial real estate and corporate debt markets. The unemployment rate rises by 5-3/4 percentage points to a peak of 10 percent and GDP declines commensurately. Asset prices decline sharply, with a nearly 40 percent decline in commercial real estate prices and a 55 percent decline in stock prices. We maintain the Fed’s assumptions in DFAST that both projections of share repurchases and dividends are set to zero over the planning horizon. The red line shows the path of the CET1 ratio under the supervisory projections for noninterest expense, which declined from 12.2 percent in the second quarter of 2020 to a minimum of 10.5 percent in the third quarter of 2021.
- But the walk-through-time approach requires further assumptions, particularly regarding the evolution of the balance sheet.
- The largest counterparty default scenario component is applied to firms with substantial trading or custodial operations.
- Any individual scenario could miss important risk exposures at individual banks or in the sector as a whole.
- Nor, given the focus on capital, does the regime address firm-specific or systemic issues related to resolution, when the shock to capital is large enough that the bank can no longer survive.
To ensure our website performs well for all users, the SEC monitors the frequency of requests for SEC.gov content to ensure automated searches do not impact the ability of others to access SEC.gov content. Current guidelines limit users to a total of no more than 10 requests per second, regardless of the number of machines used to submit requests. Acronym used by the Securities Exchange Commission and by banking and securities regulators to refer to nationally recognized statistical rating organizations. Defined by the Financial Accounting Standards Board in FAS 133 as the number of currency units, shares, bushels, pounds or other units specified in a derivatives contract. The notional amount is used to calculate the payments that are exchanged by the counterparties in the transaction. What do the watch list indicators suggest about the situation in the Federal Reserve Bank of Dallas’s Eleventh District, covering Texas, northern Louisiana and southern New Mexico?
This substitution effect could have significant consequences for both current economic activity and for systemic risk, channels that are important to understand in assessing the full impact of the programs. Some studies have looked more broadly at these substitution effects, but more work here – especially substitution into the non-bank sector – would be very helpful. The Federal Reserve assumes that the allowance at the end of each quarter covers projected loan losses for four quarters into the future. The supervisory estimate of the allowance at the start of the projection horizon, which is based on projected losses under the severely adverse scenario, may differ from a firm’s established allowance at the beginning of the projection horizon, which is based on the firm’s estimate of losses on the effective date of the stress test. Any difference between the supervisory calculation of the allowance and the firm’s reported allowance at the beginning of the projection horizon is linearly smoothed into the Federal Reserve’s provisions projection over the nine quarters. The test’s focus on commercial real estate shows that while large banks would experience heavy losses in the hypothetical scenario, they would still be able to continue lending.
Perhaps the most notable of these is that generating the supervisory projections is resource- and time-intensive, which limits the number of scenarios that can be assessed during any particular CCAR cycle. Some have suggested that stress testing would be more effective if many supervisory scenarios were examined, instead of just a few. Any individual scenario could miss important risk exposures at individual banks or in the sector as a whole. Turning that thought around, a single scenario might not uncover true capital vulnerabilities at all institutions.
The insurance must be in connection with home acquisition debt, and the insurance contract must have been issued after 2006. For best practices on efficiently downloading information from SEC.gov, including the latest EDGAR filings, visit sec.gov/developer. You can also sign up for email updates on the SEC open data program, including best practices that make it more efficient to download data, and SEC.gov enhancements that may impact scripted downloading processes. Exposure rose again with the onset of higher interest rates in 2022 and remained elevated during most of 2023—likely a symptom of the spring banking crisis—before declining. 11 Sales, purchases and acquisitions that have been contractually agreed by but not consummated by the start of the stress test are incorporated into the projections, however. Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.