LO 56.1: Describe the historical evolution of the stress testing process and compare

LO 56.1: Describe the historical evolution of the stress testing process and compare methodologies of historical EBA, CCAR and SCAP stress tests.
In the wake of the financial crisis, there was much uncertainty about the soundness of the U.S. banking system. Regulators needed to assess the capital strength of financial institutions. If there was a gap between what a bank needed in terms of capital and what it had, regulators had to find a credible way to fill the hole. The 2009 U.S. bank stress test, known as the Supervisory Capital Assessment Program (SCAP), was meant to serve that purpose. It was the first macro-prudential stress test after the 20072009 financial crisis. Macro-prudential regulation focuses on the soundness of the banking system as a whole (i.e., focuses on systematic risks) while micro-prudential regulation focuses on the safety and soundness of the individual institution.
At this point the Federal government planned to infuse equity capital into banks that were undercapitalized based on stress testing. The Treasury intended to borrow money and downstream it as equity in banks via the Treasurys Capital Assistance Program (CAP). If banks could not convince investors to fill the hole (i.e., infuse banks with needed equity capital), current investors would be diluted by the governments equity investment. In the end, 19 SCAP banks were required to raise $75 billion within six months. The undercapitalized banks raised $77 billion of Tier 1 common equity and did not need to draw on the CAP funds.
Prior to 2009, stress testing was relatively simple. Figure 1 summarizes the differences in stress testing pre-SCAP and post-SCAP.
Figure 1: Comparison of Stress Testing Pre-SCAP and Post-SCAP
Pre-SCAP Primarily assessed exposure to single-shocks (e.g., volatility increases OR interest rate increases OR increasing unemployment). Focused on specific bank products or business units (e.g., lending or trust).
Typically focused on earnings shocks (i.e., losses) but not on capital adequacy.
Focused exclusively on losses. Stress testing was static in nature.
Post-SCAP Considers broad macro-scenarios and market-wide stresses with multiple factors occurring/changing at once, as evidenced in the 2007-2009 financial crisis. Focuses on the whole firm, a more comprehensive look at the effect of the stress scenarios on the institution. Explicitly focuses on capital adequacy. Considers the post-stress common equity threshold to ensure that a bank remains viable. Focuses on revenues, costs, and projected losses. Stress testing is now dynamic and path dependent.
Professors Note: We w ill compare and contrast SCAP, CCAR, and EBA stress tests later in this topic.
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Topic 56 Cross Reference to GARP Assigned Reading – Schuermann
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