Fed urged to introduce annual high-rate stress tests

Experts broadly agree the US Federal Reserve’s inaugural stress test of interest rate risk was a success. But to get the full benefits, it shouldn’t just be a one-off exploratory scenario.

“It is hard to guess how economic conditions will change in the next six months, and how they would influence the choice of scenarios,” says Til Schuermann, a partner at Oliver Wyman who previously worked at the New York Fed developing the original post-2008 stress-testing regime. “But I do think it is important to keep rates-up or stagflation scenarios in the mix for some time, since exploring a range of shocks in interest rates is an important way to understand banks’ exposure to interest rate risk.”

According to consumer price index readings reported by the Labor Department last week, US inflation eased in June to its lowest level in four years, drawing the Fed one step closer to cutting interest rates. Five sources agree both the stress test results and the latest inflation report are encouraging, but they emphasise regulators’ oversight of interest risk should be consistent.

“Ideally, banks should run an additional interest rate scenario every year,” says Cristian deRitis, deputy chief economist at Moody’s Analytics. “Even if we expect that they’ll pass it 100% of the time, it is still a good benchmark to have.”

The Fed has so far chosen not to implement the global standards on interest risk in the banking book (IRRBB) finalised by the Basel Committee on Banking Supervision in 2016. The failure of Silicon Valley Bank last March, triggered by huge uncrystallised IRRBB losses, prompted a fresh wave of questions about why the Basel standard has not been adopted in the US.

Exploring a range of shocks in interest rates is an important way to understand banks’ exposure to interest rate risk

Til Schuermann, Oliver Wyman

However, the IRRBB standards were not included in the more than 1,000 pages of draft Basel III implementation proposed by US regulators in July 2023.

Instead, the Fed introduced four new exploratory scenarios for the first time this year as part of the Comprehensive Capital Analysis and Review (CCAR), to understand risks not covered in the core stress test. Two of those scenarios assess the risk of a rise in rates that leads to more expensive funding and a fall in asset origination.

The test results, published in aggregate form on June 28, show the largest US banks are generally well positioned to withstand the high-rate scenarios, remaining above minimum capital requirements in aggregate.

While the results are reassuring, deRitis says the additional regulatory effort was still worthwhile, because US banks have shown a degree of “complacency” in managing interest rate risks: “We don’t want to be surprised again by an SVB type of situation.”

However, other sources are sceptical whether the exercise has gone far enough to make up for the lack of the Basel IRRBB framework in US regulation.

“I sense the Fed simply wanted to put something in [CCAR] to deflect any criticism of not having considered SVB properly,” says Paul Newson, an IRRBB consultant who was formerly head of non-traded market risk at Lloyds Banking Group.

No capital impact

The results of this year’s exploratory scenarios do not feed directly into capital requirements for US banks. This is in contrast with the Basel standards, which can result in capital add-ons for outlier banks, or the main part of CCAR, which feeds into the stress capital buffer (SCB) that forms part of banks’ Pillar 1 capital requirements.

However, Alla Gil, chief executive at risk management software provider Straterix and a former managing director at Goldman Sachs, thinks the exclusion of the debut interest rate scenario from capital requirements was the right decision. At this stage, it was better to encourage banks to make an honest risk assessment without the fear of immediate capital implications.

“Holding more capital is not the answer to all questions – people sometimes are afraid to run stress scenarios, just because they’re afraid they will have to hold more capital.”

For that reason, she suggests that even if the IRRBB stress scenario becomes an annual addition to the CCAR, it should not be included in the SCB or other capital requirements.

The Federal Reserve declined to comment for this article.

Future scenarios

Under this year’s two exploratory scenarios on funding stress, banks are required to assume 20% of their non-interest-bearing deposits move into time deposits, which typically pay out a higher rate to the depositor. Banks would also have to raise rates paid on existing time deposits, or turn to more costly wholesale funding.

In addition, inflation rises in both scenarios for several quarters, peaking at 6% and 5.3%, respectively, before declining gradually under a severe stagflation scenario, and more quickly under a moderate stagflation scenario. In the severe scenario, banks suffered an aggregate 2.7 percentage point depletion in common equity tier 1 (CET1) capital, to a minimum of 10%. In the moderate scenario, the depletion was 1.1 percentage point.

For next year, Viktor Tsyrennikov, co-head of quantitative services and analytics at consultancy IBM Promontory, suggests the Fed could consider scenarios with even more significant interest rate hikes. This could involve levels akin to the past efforts to combat high inflation, such as the rates above 10% seen in the 1980s. “It is not implausible even in light of the latest inflation read,” he says, adding that it would be even better if the Fed can come up with more creative scenarios.

All exploratory scenarios this year assumed that the yield curve would normalise, but in the UK, the yield curve was inverted 42% of the time over the past 40 years

Alla Gil, Straterix

“To force the Fed to keep rates high in the scenario, you need to keep inflation high, perhaps through an adverse supply shock like we experienced in the pandemic or in the oil crisis in 1973,” suggests Schuermann. “Considering the impact of some of the geopolitical crises that are playing out in the world is, I believe, a fruitful place to look for stress scenario ideas.”

In addition to stagflation scenarios, Gil says the Fed should consider a scenario where the current inverted yield curve shape remains for a prolonged period. This scenario would make it difficult for banks to issue new long-term loans at higher rates, while facing a growing shock on their short-term funding costs.

Since early July 2022, the Treasury yield curve in the two-year to 10-year segment has been continuously inverted, exceeding a record 624-day inversion in 1978.

“All exploratory scenarios this year assumed that the yield curve would normalise, but in the UK, the yield curve was inverted 42% of the time over the past 40 years,” says Gil. “Some of these inversion periods lasted as long as four to five years in a row – who says this is not possible in the United States?”

Scenario transparency

More complex or extreme scenarios become harder for banks to translate in terms of balance sheet impact. Francisco Covas, head of research at Bank Policy Institute, says BPI is not against adding more exploratory scenarios, including those high-rate scenarios. However, the Fed would then need to provide banks with more information about the objective and reasoning behind any new scenarios introduced in the future. He says the level of information provided this year was “generally disappointing”.

“When interest rates rise, banks will make more revenues in net interest income, but then if the Fed decides to offset some of those revenues by having a funding shock, they should have more discussion about the calibration of the shock,” says Covas.

In particular, he would like to see analysis explaining the Fed’s assumptions around the sources of the funding shock, and the reasons why these assumed sources are good proxies.

“We’d like to have more information to make sure that their decisions and assumptions are grounded in empirical data,” says Covas.

Tsyrennikov and deRitis think BPI’s request for greater transparency from the Fed regarding the exploratory scenarios is a reasonable suggestion that is beneficial to all. By understanding the Fed’ thought process and rationale, both risk managers at banks and other industry participants can develop useful scenarios on their own more effectively to assess a broader range of risk internally.

In addition to more information about the scenarios, Schuermann says more disclosure of the results would also be welcome. Given the novelty of these scenarios, Schuermann empathises with the Fed’s cautious disclosure approach, including the decision to release the results in aggregate rather than individually. However, he suggests the Fed could contemplate disclosing more granular breakdowns of the impact aggregated across the banks.

Currently, the Fed discloses the impact in terms of CET1, total pre-provision net revenue, and provisions as a share of risk-weighted assets. Schuermann says it would also be helpful to see losses by major categories, such as credit cards, mortgages, and commercial real estate, which would help stakeholders understand the vulnerabilities of specific business models.

“Since interest rate shocks are explored, it would be useful to learn about the aggregate impact on net interest income,” says Schuermann. “This would educate the market more about what kind of impact the different exploratory scenarios have on bank financials without revealing individual bank results which could have a destabilising effect.”

Not very stressful?

The extra information isn’t just valuable for the banks that have to run the stress test. Other stakeholders such as investors will want to be able to assess the quality of US banks’ interest rate risk management.

“It is hard to derive any specific findings and the Fed’s own conclusions are pretty bland,” says a senior regulatory capital specialist at a European bank. “How valid is the stagflation scenario, with 20% of deposits shifting to time deposits? No-one can say.”

Consequently, the regulatory capital specialist thinks requiring US banks to publish the Basel standard IRRBB metrics would be a more effective way to bridge the information gap.

Others are even more sceptical about the value of the whole exercise. For example, if all SVB had suffered was 20% of its depositors moving to time deposits, it would not have posed a solvency threat to the bank, according to Newson: “A bit of a decline in income, yes, but not a run on the bank.”

“Applying the same, very watered down, shock to a group of sensibly run banks has, surprise surprise, indicated no problem at all,” Newson concludes.

This article was originally published on sister title Risk.net.