Global Market Shock and Large Counterparty Default Study
Recommendations for Reforms Based on a Statistical Analysis of Stress Testing Scenarios
In this white paper, we apply statistical analysis of stress testing scenarios to evaluate the stress testing approach of the Comprehensive Capital Analysis and Review (CCAR) to the trading book. The study attempts to answer a simple question: does the available evidence indicate that Global Market Shock (GMS) and Large Counterparty Default (LCD) shocks from recent CCAR cycles are plausible?
The study concludes that, in a number of significant areas, GMS/LCD shocks are not reasonably plausible and it is, therefore, important to revisit key aspects of CCAR. The CCAR framework as applied to trading book exposures has not been revised since adoption over ten years ago and, as a result, is unsophisticated relative to the significant advancements in the prudential regulatory framework and risk management practices that have been made since that time.
We urge the Federal Reserve Bank to act promptly to revise the GMS and LCD components of the CCAR program. SIFMA stands ready to facilitate a dialogue between the industry and the Federal Reserve Bank and other policymakers to help ensure that the CCAR process evolves and advances in a way that supports its relevance to risk management practices.
Excerpt
Introduction
To promote the stability of the financial system, the Federal Reserve Board (FRB) is responsible for regulating and supervising various financial entities. One of the tools the FRB uses to fulfill its mandate is stress testing of financial institutions.
The FRB has adopted a formal standard that, the severely adverse scenario of the Comprehensive Capital Analysis and Review (CCAR) program, the Global Market Shock (GMS) component should consider “hypothetical but plausible outcomes.”1 Unlike the macroeconomic component of CCAR, where the FRB has adopted formal unemployment rate and house price decline quantitative targets for the severely adverse scenario, the FRB has not adopted any quantitative thresholds for determining what severely adverse scenario shocks are “plausible” in the GMS component. The Study attempts to answer a simple question: does the available evidence indicate that GMS and Large Counterparty Default (LCD) shocks from recent CCAR cycles are plausible?
To answer this question, the Study evaluated the probability of various GMS/LCD shocks from the past several years. In many cases, the statistical probability of a GMS/LCD shock is extremely low. For example, as summarized in the pages that follow, the statistical probability of 2019 GMS spreads for certain corporate bonds occurring is 0.001%. The Study begs the question: should a one-in-one hundred thousand probability be deemed to be “plausible” within the meaning of the FRB’s scenario design standard?
The Study does not propose a formal quantitative threshold for determining what GMS/LCD shocks should be deemed plausible. However, for reference, it is worth keeping in mind that the FRB modeled the Macroeconomic component’s unemployment rate and house price decline quantitative targets on observed economic data from recent severe recessions. the 10 percent unemployment rate target, for example, is “the average level to which it has increased in the most recent three severe recessions.”2 The FRB’s approach to calibrating severity in the macroeconomic component suggests that “plausible” shocks under the GMS should align with observed stress market conditions from recent severe recessions.
The Study concludes that, in a number of significant areas, GMS/LCD shocks are not reasonably plausible. In many areas, GMS/LCD shocks do not replicate, or approximate levels of severity observed in recent severe recessions, and in some key areas effectively impose double counting that exaggerates loss assumptions well beyond historic experience. In other cases, the assumptions that govern GMS/LCD shocks appear to be illogical, resulting in exaggerated stress loss estimates that do not align with plausible assessments of market or counterparty risk. Reasonably plausible GMS shocks are critical to the GMS and LCD components of the stress test, as they are the single tool that the FRB uses to size the test’s severity. Unnecessarily severe calibration of shocks results in excessive capital requirements relative to potential risk, which create uneconomic outcomes for firms, their clients and the market. These exaggerated stress loss estimates include instances where particular trading assets are subject to multiple, unreconciled stress loss assumptions, which can result in capital requirements that exceed trading assets’ carrying value or other double counting that are analytically unsupported. The effect of implausible or illogical GMS/LCD shock calibrations and assumptions should be assessed not only in isolation, but also cumulatively; the coherence and risk management value of the GMS component are weakened if the GMS is not grounded in a reasonable assessment of banking institutions’ actual vulnerabilities.
The Study provides detailed calculations in support of its conclusions, with the objective that open, transparent engagement will result in future GMS/LCD shocks that more clearly meet the FRB’s stated objective of “hypothetical but plausible outcomes.” In time, with further data analysis, we believe that the formal standards governing the GMS component could evolve to include quantitative targets analogous to the unemployment and house price decline ratios, thereby improving the coherence of CCAR stress loss analysis and strengthening its utility in risk management.
1 12 C.F.R. § 252 Appendix A Section 5.2.3(c).
2 12 C.F.R. § 252 Appendix A Section 4.2.2.