Key Takeaways

• The Fed will, for the first time, be conducting a second round of stress tests this year designed to capture potential risks arising from the ongoing COVID-19 crisis.
• We recommend that the Fed design their macroeconomic scenarios with a focus on those segments of the economy that are currently distressed or likely to be vulnerable to stress, rather than applying blunt, broad based macro scenarios.
• The Fed should consider tailoring the Global Market Shock and Large Counterparty Default components to focus more specifically on those asset classes that are plausibly vulnerable or potentially vulnerable to the impact of COVID-19 transmission. Conversely, the Fed should also give recognition to those asset classes which are not vulnerable or are only remotely vulnerable to a continued the COVID-19 event.
• Finally, because this is the first time the off cycle stress test has been deployed and the purpose is somewhat altered from the normal BAU CCAR, it is critical that the Fed prepares the market by disclosing details around scenario severity, how results will be presented and what the capital implications of those results will be.

When the Federal Reserve (”the Fed”) issued the results of its 2020 stress tests (which included a  COVID-19 “sensitivity analysis”), it also announced that firms would be required to resubmit and update their capital plans later this year to reflect an updated view of potential stress scenarios . We expect that the Fed will announce new stress scenario in the early fall and require firms to resubmit plans 45 days after the publication of the scenarios.

The Fed’s decision to use its authority to conduct an off-cycle stress test later in the year is unprecedented. Per the capital plan rule, an off-cycle stress test can be conducted when a single banking organization has material changes in its risk profile or financial resources, or, as in this case, when there are significant changes in the economic outlook that will impact all banking organizations.

In our view the rationale for the off-cycle stress test is important and should dictate its approach to the test and inform the scenarios. Given, there are very direct and important links to the sources of economic uncertainty and the transmission of the COVID-19 virus, we think it is reasonable the Fed would target those segments of the economy which are currently distressed or likely to be vulnerable rather than apply blunt, broad based macro scenarios. This same approach should extend to the design of the Global Market Shock (“GMS”) and the Large Counterparty Default (“LCD”) scenarios.

Additionally, because this is the first time the off cycle stress test has been deployed and the purpose is somewhat altered from the normal business-as-usual Comprehensive Capital Analysis and Review (“CCAR”), it is critical that the Fed prepares the market by disclosing details around scenario severity, how results will be presented and what the capital implications of those results will be. This will help ensure the continued resiliency of the banking sector, which is critical to the government’s response to the current crisis and our ultimate economic recovery.

Macro Scenario Development and Severity

The composition and the severity of the macroeconomic scenarios are critical; how they are designed will determine whether this is a meaningful analysis of the potential implications of the current stressed environment or just an exercise designed to raise capital requirements. For this exercise to be valuable to supervisors, to firms, and to the market, the scenarios need to be rooted in defensible expected and potential economic outcomes. In short, the scenarios should be severe but plausible, but, more importantly, with reasonable ties to how the virus’ transmission could impact the economy.

A surgical focus on the susceptible sectors of the economy as the macro scenarios are designed will help to identify where the pockets of risk are in firms and ensure that there is sufficient capital to mitigate against those vulnerabilities. At this juncture, we know that the economic impact of the current crisis is having an uneven impact across sectors, borrower types, and geographic locations. Clearly, certain sectors are experiencing more strain or more likely to come under pressure. For example, there are stresses in the Commercial Real Estate (“CRE”) market, primarily focused on hotels, leisure properties and retail space, though office space in certain locations may prove to be a source of potential vulnerability depending on the length of the current crisis. Similarly, in the energy sector, due to shifts in consumer and corporate behaviors arising from the COVID-19 event, demand for certain commodities will negatively impact some providers more than others. The macroeconomic scenarios should be designed in ways that capture the disparate impacts of the current crisis.

Global Market Shock and Large Counterparty Default Scenarios

The GMS and LCD components of the stress test are designed to measure the impact of an exogenous event that is independent of the macroeconomic and financial environment described in the severely adverse (9-quarter) scenario. Given the purpose of this off-cycle stress test,  the Fed should consider tailoring the GMS factors to focus more specifically on those asset classes  which are plausibly vulnerable or potentially vulnerable to the impact of COVID-19 transmission. Conversely, the Fed should also give recognition to those asset classes which are not vulnerable or are only remotely vulnerable to a continued the COVID-19 event.  This tailored approach would avoid overly severe and procyclical outcomes that could undermine the positive effects of the Fed’s emergency programs to assist the economy economic sectors which have been most impacted.

Continuation of the Government Support

Given the broad application of the off-cycle stress test and the US Congress, US Treasury and the Fed’s continued commitment to using its full range of tools to support households, businesses, and the economy, it would be reasonable to factor in continued government support into the stress test scenarios. Under normal circumstances, such an assumption would not be permitted in the CCAR/Dodd-Frank Act Stress Test (DFAST) process, given such programs would be highly idiosyncratic and employed only under extraordinary circumstances. However, emergency government facilities are not theoretical in this instance, but have already been implemented on a broad scale. Moreover, according to numerous statements by both the Chair of the Federal Reserve and the Secretary of the Treasury, they are certain to remain in place through at least the end of the year (and likely until the current crisis subsides). Therefore, assuming continued government support for certain portfolios and exposures would seem prudent.

Disclosures to Firms and Markets

Given this is the first time an off-cycle stress test has been implemented and the Fed has announced a short capital plan submission cycle (45 days), it is critical firms are provided documentation regarding the approach and expectation well in advance of publication of the macroeconomic scenarios.

In addition, while supervisors will obviously want to have as much time to gather and analyze the most up-to-date economic information, that should not preclude them from publicly disclosing information on the process and their expectations as soon as possible. While the banking sector continues to benefit from sustained market confidence, this second round of tests and their outcomes could have potentially adverse consequences if they are not communicated to the markets appropriately. As such, the Fed should act soon to begin educating the markets on the objectives of the stress test and the range of potential outcomes, placing the exercise in proper context as a precautionary rather than reactive measure. Doing so will mitigate unduly negative market impacts on the sector during a time when financial institutions are playing a critical role in supporting both the markets and the real economy.

Coryann Stefansson is Managing Director and Head of Prudential Capital & Liquidity Policy at SIFMA, and Peter Ryan is Managing Director and Head of International Capital Markets & Prudential Policy at SIFMA.