Last month, the Federal Reserve Board published proposed refinements to its annual Comprehensive Capital Analysis and Review (CCAR) exercise—the supervisory stress test that evaluates the capital adequacy of the largest U.S. banks (34 in the 2017 test). In our view, the Federal Reserve has an effective framework for carrying out these all-important stress tests. Having started in 2011, the Fed is now embarking on only the seventh CCAR exercise. That means that everyone is still learning how to best structure and execute the tests. The December proposals are clearly in this spirit.
With this same goal in mind, we make the following proposals for enhancing the stress tests and preserving their effectiveness:
--- Change the scenarios more aggressively and unexpectedly, continuing to disclose them only after banks’ exposures are fixed.
--- Introduce an experimental scenario (that will not be used in “grading” the bank’s relative performance or capital plans) to assess the implications of events outside of historical experience and to probe for weaknesses in the system.
--- As a way to evaluate banks’ internal models, require publication of loss rates or risk-weighted assets for the same hypothetical portfolios for which the Fed is disclosing its estimates.
--- Stick with the annual CCAR cycle....