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Last year's Fed stress test included $110 oil, showing limits of exercise

The views and opinionsexpressed in this piece are those of the author and do not necessarilyrepresent the views of S&P Global Market Intelligence. Share your thoughtsat zfox@snl.com.

As banksfinalize stress test submissions for an April 5 deadline, a quick glance atlast year's exercise shows banks could face a very different 2017 and 2018 thanwhat the Federal Reserve outlines in its various .

Inthe last two stress tests, the Fed's base-case scenarios have overshot interestrates. And in last year's stresstest, the Fed's severely adverse scenario asked banks to considerwhat loan losses would look like if oil reached $110 per barrel. Since then,oil has collapsed, bouncing around $30 per barrel to start the year andpresenting anentirely different set of issues for banks and the economy.

Whilestress tests are not intended to be economic forecasts, the disparity betweenthe Fed's scenario and reality underscores the difficulty of ensuring banks areprepared for the next crisis.

"Onething that people point out time and time again is that if you only looked inthe rear-view mirror in 2006, you would never expect a 30% decline in homeprices," said David Wright, a managing director for Deloitte & ToucheLLP.

TheFederal Reserve declined to comment.

Thebase-case assumptions, by design, represent conventional wisdom as an averageof various economic predictions from forecasters. The adverse and severelyadverse scenarios then stress bank holdings with a variety of economic shocks.

Despitethe differences on some variables, Wright said the stress tests do sufficientlyevaluate the stability of bank balance sheets under adverse economicconditions. While banks are bracing for notable losses due to the collapse inoil prices, a spike in oil prices could be worse. Higher gas prices can strainconsumers, driving up losses in consumer and mortgage loan books that aregenerally much larger than oil and gas holdings.

Andoil prices represented only one of many variables. The severely adversescenario included a spike in the unemployment rate to 10.0% by the 2016 first quarter,whereas the figure clocked in at 4.9% in February.

"Thehope is that all the other shocks that you have in the stress test cover that[oil price] shock," said Chuck Morris, a vice president and economist forthe Federal Reserve Bank of Kansas City. "We had a big decline in oilprices, but there are other stress-test shocks that didn't happen."

Asfurther protection, the Fed makes each bank devise an idiosyncratic scenariothat stresses its unique vulnerabilities. Presumably, banks with heavy oil andgas exposure would devise scenarios that include a collapse in energy prices,Wright said. Also, the Fed monitors oil and gas losses through regular reviewsof the nation's largest loans through the shared national credit program.

"Ofcourse, [the shared national credit program] has been focused on oil and gasfor quite some time now," Wright said.

Thisyear, the Federal Reserve threw banks a curveball in the stress test byincluding negative interest rates, a headwind banks in Japan and Switzerlandcurrently face. Also, the Fed's scenarios are more severe on a relative basis.For example, the unemployment rate spikes by 4 percentage points in the 2016exercise, compared to a 2.1 percentage point jump in the 2015 exercise.However, because the economy is stronger, the increase is applied to a lowerbase, meaning the peak unemployment rate of 10.0% in this year's stress test islower than any of the previous three tests.

Evenwith a more rapid deterioration in the economy and the specter of negativeinterest rates, analysts said they expect banks' balance sheets to withstandthe Fed's most severe scenario.

"Thefact that capital has been built up year after year after year has made itunlikely that firms will fail on a quantitative basis," said Michael Alix,a partner with PwC.

However,Alix and Deloitte's Wright both said it was possible banks could fail thequalitative portion of the Fed's exercise, which evaluates a bank's riskmanagement procedures. That was the case last year, when the U.S. subsidiaries of andDeutsche Bank AG wereable to pass the quantitative stress test but failed on qualitative issues suchas governance and internal control deficiencies.

Thisyear, the Fed has made it very clear to banks that there will be a focus ondata quality.

"'Wheredid you get your data? How good is it and how reliable is it?' My clients aregetting a lot more questions about their data practices," said MayraRodriguez Valladares, a managing principal of bank consulting firm MRVAssociates.

Alixand Wright both agreed, saying data quality appears to be an area of focus forthe Federal Reserve in this year's stress tests.

"Firmsthat don't have a buttoned up process for reconciling and reporting the data …will be more vulnerable to a fatal problem," Alix said.

Itis hard to imagine the quantitative portion of the exercise could prepare banksfor a repeat of the 2008 credit crisis and an unexpected collapse in a certainasset, such as housing. And it is an open question whether bracing for highlyunlikely events would be wise since it would almost assuredly constrain accessto capital.

Consideringthe difficulty — perhaps impossibility — of ensuring bank balance sheets canweather the next crisis, the stress test's value might be in the qualitativeassessment.