Stress Testing 2.0

This is the sixth year of the federal Comprehensive Capital Analysis and Review (CCAR) program, and judging by the results and payouts approved, the banking industry has entered a new chapter of the post-crisis regulatory regime. There were no failures this year, quantitative or qualitative; banks were approved to pay out nearly all their expected earnings; and there are ongoing signals that the Federal Reserve Board is dialing down the intensity of the program. If crisis or wartime stress testing is about getting capital into the banks, peacetime is about letting it out, and it looks like peace has finally broken out in the United States.

In this new world, banks have far more capital than they did before the crisis; the 34 institutions that participated in the 2017 CCAR had more projected capital post-stress than was held by the entire US banking system at the end of 2006 before the dawn of the financial crisis. What’s more, after spending millions of FTE hours, developing thousands of models, and holding hundreds of board meetings, they have built a formidable stress testing process to uncover risks, probe vulnerabilities, and describe their potential consequences in excruciating detail to regulators, boards, and senior management.

The same scenario-based techniques used in stress testing can be powerful tools for day‑to‑day risk management and strategic planning, permitting companies to identify and quantify risks and opportunities across a wide range of potential economic environments. But most banks have been wary of using them for such mundane purposes. Stress testing is designed to assess the impact of the most extreme stresses banks face. It is deep and complex, but also so cumbersome and narrow that most banks leave it in the toolbox on all but the rarest occasions. That is perfectly understandable, but it is also a shame and a waste.

And it is unnecessary. Leading banks are currently building faster machinery and streamlining their capital planning process allowing for more flexibility. In this short paper, we will look at the possibilities this thing called “stress testing” has to offer, not just to risk managers who worry about the myriad ways things can go wrong, but, as importantly, to the strategic planners who look at the world as an array of opportunities.