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Moving Forward With the End in Mind: Reverse Stress Testing for Banks

For banks to stay resilient in unstable times, reverse stress testing can help show vulnerabilities before a true financial catastrophe.
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To put it lightly, 2023 was a challenging year for banks. Fifteen years after the global financial crisis, several bank failures created ripples of anxiety throughout the banking sector. Although hundreds of banks completed yet another year of in-house stress testing to evaluate their own financial strength, it appears that some banks were not adequately prepared for rising interest rates and shrinking deposit bases. As a result, the conventional approach to stress testing may no longer be comprehensive, given the state of the world and unpredictable nature of the global markets.

The global economy has seen extraordinary times, which were at one point considered only as extreme hypothetical scenarios, e.g., a global pandemic. We saw record-high unemployment during the recent global pandemic, and we are currently experiencing a period of slowing economic growth and stubborn inflation. As interest rates continue to remain high, banks need to evaluate how they are measuring the impact of these real-life and real-time scenarios on capital adequacy. Banks should further question whether their current stress testing strategies adequately identify vulnerabilities.

Most conventional stress testing for U.S. banks has long been focused on loan portfolios, even though investment portfolio losses and deposit runs can also cause a failure. As interest rates rise, the value of banks’ fixed-income investment portfolios declines. Then what happens when a bank is forced to sell portfolio securities at a loss to meet depositor withdrawals? The bank failures witnessed in 2023 are representative cautionary tales. Yet, the Federal Reserve’s last stress testing scenarios still projected low interest rates during a recession. Has anyone considered what would happen during an economic slowdown with high, not low, interest rates?

Looking Back to the Early Days of Stress Testing

The Supervisory Capital Assessment Program (SCAP) was introduced by the Federal Reserve in early 2009 as part of a governmentwide effort to restore public confidence in the U.S. banking system. The purpose of the SCAP was to demonstrate that large banking organizations had become sufficiently capitalized in the aftermath of the global financial crisis to weather future adverse economic events. By most accounts, the SCAP was a major step in restoring public confidence. In fact, the SCAP was so successful that the Dodd-Frank Act of 2010 required the Federal Reserve to conduct annual stress tests of large banking organizations and for certain large banking organizations to conduct their own “company-run” stress tests—these stress tests have become known respectively as the Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Test (DFAST). The purpose of all bank stress testing has remained the same over time: to analyze how a bank will fare when impacted by an adverse change in the economy as well as idiosyncratic risk events, and more specifically, to analyze how various adverse scenarios would impact capital adequacy and bank solvency.

Although the Fed’s initial stress testing requirements were rolled back in 2018, CCAR and DFAST remain the two stress testing programs required for banks with more than $100 billion and $250 billion in assets, respectively. Even with the rollback in regulations, banks of all sizes realized the importance of stress testing, particularly with respect to measuring capital adequacy over various economic cycles. Capital stress testing helps ensure that the bank has a sufficient capital cushion by analyzing the bank’s financial strength under severe, yet plausible, scenarios. It also forces banks to evaluate the strength of their overall risk management activities. A bank uses the stress testing exercise to project the impact of potential economic downturns on their financial statements and to evaluate the change in regulatory capital under the adverse scenarios prescribed by the Fed. The five regulatory capital ratios that are measured in the supervisory stress tests include CET 1 capital, tier 1 risk-based capital, total risk-based capital, tier 1 leverage, and, if applicable, supplementary leverage. Measuring these ratios under severe scenarios allows banks to identify risks that may not otherwise be apparent so that those risks can be better identified, measured, and mitigated. It is not enough to simply measure stress testing outcomes. Rather, banks must also develop an understanding of how those risks may manifest and develop an action plan to allow them to respond in a timely manner should adverse economic conditions arise.

Moving Forward & Testing in Reverse

An approach that is growing in usage, and something that the Federal Reserve is considering for future stress testing exercises, is the concept of reverse stress testing. Reverse stress testing starts with a failure event—such as the bank’s capital falling below adequately capitalized levels—and then an identification of the sequence of events that led to that failure. Once the sequence of events is known, one or more scenarios are modeled to identify risks and vulnerabilities that could lead to that sequence of events. This allows the bank to identify and address core vulnerabilities. While every bank engaging in reverse stress testing may start with a similar failure event, it is likely that each bank will identify a unique sequence of events that leads to that failure and unique scenarios that would lead to that sequence of events. As a result, reverse stress testing allows banks to focus on their unique vulnerabilities and to develop a tailored risk analysis. Conventional bank stress testing focusing solely on a universal hypothetical cause and effect model lacks robustness as it does not capture the unique individuality of banks, such as business models, concentrations, and portfolio mixes.

How can a reverse stress testing framework be used to evaluate capital adequacy, and what would be the scenario that could cause your bank’s capital ratio to fall below the minimum requirement? Many scenarios are out there, depending on the nature of your business and the risks at your institution. The best way to think about reverse stress testing and how it could help identify vulnerabilities at your institution is to ask yourself the questions below, with recent bank failure events in mind.

  • What could cause a failure? Hint: regulatory capital falling below the adequately capitalized level.
  • What could it take to cause the bank to fail? Hint: unrecognized losses in the bank’s available-for-sale and held-to-maturity securities portfolios are recognized, resulting in a reduction in regulatory capital.
  • What could lead to that cause? Hint: short-term funding sources leave the bank, increasing the bank’s liquidity needs and requiring the bank to sell securities to meet its liquidity needs. This could occur if (a) high interest rates create an incentive for uninsured depositors to seek alternative non-bank investments, (b) large draws on credit lines are made by customers due to concerns of an economic recession, and/or (c) unsecured creditors of the bank become concerned about the bank’s viability.
  • What could be some of the identified vulnerabilities? Hint: the bank identifies vulnerabilities due to large unrealized losses in the investment portfolio, large credit lines, a large number of uninsured depositors, and a lack of real-time transparency of the bank’s financial condition.
  • How could those vulnerabilities be addressed today? Hint: the bank may decide to manage-down the unrealized losses in its investment portfolio, identify additional sources of funding, address uninsured depositor concentrations, create robust deposit monitoring systems, reduce credit line or increase the monitoring of credit lines, and develop a communication strategy to allow the bank to respond more quickly to customer and investor concerns.

Taking a Step Back to Identify & Plan for Future Vulnerabilities

By capturing unique risks, reverse stress testing can increase banks’ resilience under stressed scenarios by encouraging strong, tailored risk management practices, and a solid capital stress testing plan. Reverse stress testing forces banks to look beyond universal risks by challenging banks to identify and address core weaknesses before it is too late. While reverse stress testing can be an important exercise to support a bank’s capital plan, it is important not to shy away from severity of the outcomes. Reverse stress testing scenarios should be severe enough to identify core vulnerabilities.

It is better to look inward now, identify what could drive your bank to fail, and work backward to identify the vulnerabilities that need to be addressed, versus having to react to a completely unplanned scenario. Evaluating the adequacy of your capital stress testing framework now, just like with liquidity stress testing, only serves to strengthen your overall risk management framework.

If you have questions or need assistance, please reach out to a professional at FORVIS.

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