Incorporating Liquidity Shocks And Feedbacks In Bank Stress Tests By Jill Cetina, OFR

Stress testing can be an important tool to assess the health of the financial system. U.S. supervisory stress tests measure the impact of hypothetical credit and collateral shocks on banks’ capital ratios. Supervisors have also begun liquidity stress tests to evaluate the effect of funding shocks on banks. This brief discusses how four types of shocks that can affect banks could be incorporated into stress tests and shows that shocks can affect regulatory ratios for capital and liquidity simultaneously. Additionally, a bank’s responses to a binding regulatory ratio in stress can spread shocks to other banks.

Banks perform several important functions for the economy. They extend credit, provide liquidity, and transform short-term liabilities, such as deposits, into long-term assets, such as mortgages. All of these functions expose banks to potential channels of stress. U.S. stress tests since the 2007-09 financial crisis have largely focused on the effect on capital from stresses on the credit and collateral channels. Stress tests pose a theoretical shock in the form of credit losses or market price declines and then model the impact on banks’ regulatory capital ratios, which measure banks’ solvency.

The principal U.S. supervisory stress tests are the Comprehensive Capital Analysis and Review and Dodd-Frank Act stress tests, but neither considers potential risks in the funding or liquidity channels.2 “Funding channel” refers to risks from changes in the price, term, mix or, in the extreme, ongoing availability of funding to the bank. “Liquidity channel” refers to unanticipated growth in a bank’s balance sheet from commitments, a backup in the loan securitizations pipeline, or other issues.

The financial crisis contained examples of funding stress and liquidity stress contributing to capital losses — as opposed to capital losses arising solely from credit losses — at banks such as Wachovia, Lehman Brothers, RBS, and Dexia. These funding and liquidity stresses included draws on loan commitments; backups in the collateralized loan obligation pipeline; asset fire sales; downgrades in credit ratings that pressured banks’ funding costs, funding availability, and solvency; and illiquid banks pulling funding from other banks.

A third supervisory stress test is the Federal Reserve’s Comprehensive Liquidity Assessment and Review, which assesses the impact of a market stress on banks’ liquidity. However, these capital and liquidity stress tests are not integrated into a common framework. Building an integrated stress test for liquidity and solvency is challenging. Integration between liquidity and solvency risks in many supervisory stress tests is limited because of the difficulty in defining possible channels for interaction to occur.

This brief sets out some ways to think about a more integrated approach to stress tests that would include funding and liquidity shocks as well as the possible second-round effects of a bank’s deleveraging. To deleverage means to sell assets quickly. This brief illustrates how different shocks can result in banks engaging in transactions to maintain compliance with regulatory ratios and what the potential implications of such transactions could be on other banks through deleveraging.

Feedbacks In Bank Stress Tests

Regulatory Ratios

Large U.S. banks must comply with multiple regulatory constraints (see Figure 1). In the next few years, capital standards — most prominently the risk-based capital ratio and the leverage ratio3 — will be joined by new liquidity standards, the liquidity coverage ratio and net stable funding ratio.4 Minimum capital standards were reformed and liquidity standards developed by the Basel Committee on Banking Supervision, an international forum of bank supervisors. These new global capital and liquidity standards for banks are collectively referred to as Basel III.

The potential interactions of these regulatory constraints are not fully understood. In the extreme, banks seeking to avoid a breach in one ratio could create undesirable consequences for financial stability, such as deleveraging and asset fire sales. Even less extreme actions by banks could create systemic feedback effects, because banks might try adjustments to affect cashflows to minimize the risk of breaching a regulatory ratio. For example, banks might reduce interbank lending, reduce long-term lending to corporations and households, or hoard collateral. Understanding potential bank responses to the threat of breaching a required regulatory ratio is important, because an individual bank’s response to stress could place stress on other banks and spread shocks throughout the financial system.

Feedbacks In Bank Stress Tests

Impact of Potential Shocks on Bank Regulatory Ratios

This section discusses shocks related to credit, funding, liquidity, and collateral. Figure 2 shows a typology of shocks along with key regulatory ratios under Basel III that can become binding on banks when the shocks are realized. Figure 2 yields two important observations. First, the net stable funding ratio is sensitive to all four types of shocks because it incorporates both capital and funding. Second, the addition of liquidity shocks to the suite of supervisory scenarios would provide more comprehensive coverage of risks to a firm’s capital adequacy in stress because a bank’s risk-based capital ratio or leverage ratio could be breached from unanticipated balance sheet growth.

Credit Shock. Supervisory stress tests primarily focus on the credit channel and the associated impact from a credit shock on bank’s risk-based capital ratios. However, credit shocks also directly affect banks’ leverage ratios and net stable funding ratios. Specifically, capital losses or higher loan loss provisions could reduce capital and worsen banks’ leverage ratios.5 Reductions to capital will also affect banks’ available stable funding and lower their net stable funding ratios. The empirical effect on funding costs and market access remains to be seen of a bank breaching its capital conservation buffer, a new element to capital requirements for U.S. banks. Under the final U.S. capital rule, banks must cut their dividends if they breach the capital conservation buffer, an additional 250 basis point cushion on top of the minimums assessed under the Comprehensive Capital Analysis and Review. Cuts to dividends may affect banks’ share prices and share price volatility, which could negatively affect market perceptions of a bank’s creditworthiness and affect its access to funding.

Feedbacks In Bank Stress Tests

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