A stress test is an assessment or evaluation of a bank's balance sheet to determine if it is viable as a business or likely to go bankrupt instead. It is a colloquial term often used in relation to the Supervisory Capital Assessment Program (SCAP), a forward-looking appraisal of capital conducted by the Federal Reserve and thrift supervisors to determine if the 19 largest financial institutions in the U.S. have sufficient capital buffers to withstand the recession and financial crisis. Regulators chose Tier 1 common capital as the yardstick to assess capital levels, although it was originally thought that they would use tangible common equity.
Each financial institution was asked to estimate two figures over a two-year time horizon starting in 2009 and ending in 2010. These figures were: a) potential losses from loan, securities and investment portfolios, including off‐balance sheet commitments and contingent liabilities and exposures; and b) the resources available to absorb these potential losses, including pre‐provision net revenue (PPNR) and allowance for loan and lease losses (ALLL).
These estimates were arrived at under the assumption that one of two macroeconomic scenarios would play itself out over the next two years. These scenarios were: a) the baseline scenario, which reflected the consensus expectation of professional forecasters in February 2009 on the depth and duration of the recession; and b) the more adverse scenario, which was designed to reflect an recession that is longer and more severe than the consensus expection.
Error creating thumbnail Error creating thumbnail Error creating thumbnail
As mentioned earlier, the baseline scenario was intended to represent a consensus view about the depth and duration of the recession. As such, the baseline assumptions for GDP growth and the unemployment rate in 2009 and 2010 were estimated to be equal to the average of forecasts published in February 2009 by Consensus Forecasts, the Blue Chip survey and the Survey of Professional Forecasters. In addition, the baseline assumptions for house prices were estimated to be consistent with the path implied by futures prices for the Case‐Shiller 10‐City Composite Index in February 2009 and the average response to a special question on house prices in the Blue Chip survey.
The more adverse scenario was intended to reflect the possibility that the economy could turn out to be appreciably weaker than expected under the baseline outlook. As such, the more adverse assumptions for GDP growth and the unemployment rate in 2009 and 2010 reflect a deeper and longer recession than the baseline assumptions, and were constructed from the historical track record of private forecasters as well as their current assessments of uncertainty. In addition, the more adverse assumptions for house prirces were estimated to be about 10% lower at the end of 2010 relative to their level in the baseline scenario. Note that the more adverse scenario is not intended to be a worst case scenario, but to reflect conditions that are severe yet plausible.
|Baseline and More Adverse Scenarios|
|Real GDP (percent change in annual average)|
|Survey of Professional Forecasters||-2.0||2.2|
|Alternative More Adverse||-3.3||0.5|
|Civilian Unemployment Rate (annual average)|
|Survey of Professional Forecasters||8.4||8.8|
|Alternative More Adverse||8.9||10.3|
|House Prices (percent change in Case‐Shiller 10‐City Composite Index)|
|Alternative More Adverse||-22||-7|
The bank stress test results were released on 7 May 2009. They indicated that, if the economy were to track the more adverse scenario, losses in 2009 and 2010 at the 19 financial institutions assessed could be $600 billion. Of this amount, approximately $455 billion would be losses from accrual loan portfolios, particularly from residential mortgages and other consumer-related loans, while the remaining $135 billion would be losses from trading-related exposures and securities held in investment portfolios, specifically from charge-offs and write‐downs on the values of securities.
Besides estimating potential losses at these firms in 2009 and 2010, the stress tests also assessed potential resources available to absorb these losses. At the end of 2008, capital ratios at all 19 bank holding companies exceeded minimum regulatory requirements and Tier 1 capital at these firms totaled $835 billion. Nonetheless, 10 of the 19 assessed banks were ordered to raise $75 billion in additional capital buffers, most of which would need to be Tier 1 common capital. Regulators had originally required that the banks raise $185 billion in additional capital buffers, but noted that asset sales and capital restructuring had reduced this amount by $110 billion.
|Aggregate Results for 19 Participating Bank Holding Companies for the More Adverse Scenario|
|At 31 December 2008||in $ billions|
|Tier 1 Capital||836.7|
|Tier 1 Common Capital||412.5|
|Estimated for 2009 and 2010 for the More Adverse Scenario||in $ billions||as % of loans|
|Total Estimated Losses (before Purchase Accounting Adjustments)||599.2|
|First Lien Mortgages||102.3||8.8%|
|Second/Junior Lien Mortgages||83.2||13.8%|
|Commercial and Industrial Loans||60.1||6.1%|
|Commercial Real Estate Loans||53.0||8.5%|
|Credit Card Loans||82.4||22.5%|
|Securities (AFS and HTM)||35.2||-na-|
|Trading & Counterparty||99.3||-na-|
|Memo: Purchase Accounting Adjustments||64.3|
|Resources Other Than Capital to Absorb Losses in the More Adverse Scenario||362.9|
|SCAP Buffer Added for More Adverse Scenario|
|Indicated SCAP Buffer as of 31 December 2008||185.0|
|Less: Capital Actions and Effects of Q1 2009 Results||110.4|
In the more adverse scenario, the estimated two-year cumulative loss rate on total loans equaled 9.1%, especially high by historical standards. As shown in the chart, this loss rate was higher than the two-year loss rates observed for U.S. commercial banks from 1920 to 2008.
To evaluate losses for securities in available-for-sale (AFS) and held-to-maturity (HTM) portfolios, regulators focused on securities subject to credit risk. At the end of 2008, the 19 assessed banks held $1.5 trillion worth of securities. More than one‐half of these securities were Treasury, agencies or sovereign securities, or high-grade municipal debt, and so subject to limited or no credit risk. About $200 billion was in non‐agency mortgage‐backed securities (MBS). For securitized assets, regulators assessed if the security would become impaired during its lifetime and, if so, the security was written down to fair value with a corresponding other than temporary impairment (OTTI) charge equal to the difference between book and market value. These OTTI charges equaled $35 billion in the more adverse scenario, with almost one‐half of the estimated losses coming from the non‐agency mortgage-backed securities.
Firms with trading assets of $100 billion or more were asked to estimate potential trading‐related market and counterparty credit losses under a market stress scenario based on the severe market shocks that occurred in the second half of 2008. The estimated losses from trading‐related exposures were substantial, close to $100 billion across the five firms to which it was applied. The primary drivers of potential stress losses were private equity holdings, other credit‐sensitive trading positions and possible losses stemming from counterparty credit exposures to over‐the‐counter (OTC) derivatives trading counterparties.
On 3 May 2009, renowned investor Warren Buffet criticized the stress tests being conducted on the 19 largest U.S. banks on the grounds that "a one-size-fits-all attempt to identify capital shortfalls was inappropriate". He argued that stress tests were not necessary for 15 of the 19 banks being evaluated because they were not too big to fail and did not pose that kind of risk. He also added that all but 4 of the banks being tested could easily be sold with the assistance of the Federal Deposit Insurance Corporation.