On February 15, the Federal Reserve Board released the hypothetical scenarios for DFAST 2024 and an exploratory analysis1. The latter can lead to integrated stress testing and potentially become a significant evolution of the regulatory stress test program.
The scenarios run from the first quarter of 2024 through the first quarter of 2027. This year, the capital positions of 34 banks will be tested against the standard DFAST scenarios as part of CCAR.
DFAST 2024 is the first scenario release since the regional bank crisis of last spring. Thus, drawing upon the lessons learned from that crisis and following the recent call from the Fed Vice Chair for Supervision Michael Bar for multiple exploratory scenarios2, the Federal Reserve Board also released an exploratory analysis for gauging banks’ resiliency against economic and financial conditions including funding stress that are different from the ones in the standard stress scenario.
I have been a strong proponent of integrated stress testing that simultaneously forecasts risks on both sides of the balance sheet. Although the results from the exploratory analysis will not affect capital requirements for the banks, I applaud the Fed’s initiative to introduce scenario analysis that would facilitate such integrated stress testing.
Hence, I would strongly recommend more than ever that this year’s scenarios and exploratory analysis be adopted by regional and community banks regardless of their size. Of course, in those cases the scenarios should be adapted to the geographical footprint and asset/liability profile of the respective banks as advocated elsewhere3.
We next review the standard scenarios and exploratory analysis of DFAST 2024 by focusing on key macroeconomic factors and addressing three questions:
- How does the 2024 severely adverse scenario compare with the 2023 severely adverse scenario?
- What do any differences imply for potential impact on the banks’ losses relative to last year’s test?
- How do the economic conditions of the exploratory analysis compare with the 2024 severely adverse scenario?
Figures 1-6 depict the standard scenarios of DFAST for the following six macroeconomic factors:
- Real GDP in Figure 1
- Unemployment rate in Figure 2
- House price index (HPI) y/y change in Figure 3
- CRE Price Index y/y change in Figure 4
- BBB spread in Figure 5 and
- Stock market index q/q change in Figure 6
The 2023 severely adverse scenario is included as a dashed orange line in each of the above figures. The quarter of the trough/peak in the severely adverse scenario of each macroeconomic factor is also denoted.
More specifically, under the 2024 Severely Adverse Scenario:
- Real GDP bottoms in Q1 2024, at a value equal to the 2023 severely adverse scenario and with a similarly slow trajectory to recovery. This implies a neutral effect on losses compared to the 2023 losses.
- Unemployment Rate in the 2024 scenario peaks in Q3 2025 at the same peak level as in 2023. Thus, this also implies a neutral effect on losses compared to 2023.
- Similarly, HPI y/y change in the 2024 scenario bottoms in Q4 2024, at a value slightly higher than the 2023 scenario. Although it is significantly lower than the trough of the Great Recession, this implies a slightly negative effect (decrease) on losses for residential mortgages relative to 2023.
- CRE price index y/y change in the 2024 scenario exhibits a similar recession trajectory than in the 2023 scenario. It bottoms in Q4 2024 with the same trough value as in the 2023 scenario. We would therefore expect similar losses for CRE compared to 2023.
- BBB spread widens and recovers identically to the 2023 scenario, peaking in Q4 2024 at the same level. The widening of the spreads starts from a slightly lower level in the 2024 scenario than in 2023 (170 vs. 220). Nevertheless, we would expect a neutral effect on C&I loan losses compared to the 2023 scenario.
- At the same time, the DJ stock market return bottoms in Q1 2024 at a level much lower than the 2023 scenario, i.e., 45% vs. 37%. This implies a slightly positive effect (increase) on losses. Like the 2023 scenario, the stock market return is assumed to have 0% growth throughout the Baseline scenario.
Since the 2024 severely adverse scenario is overall very similar to the 2023 one, we would expect similar losses to be forecasted again this year, adding to the predictability of this regulatory scenario4.
There are two sets of economic and financial conditions in the exploratory analysis for examining the effects of funding stresses including a swift repricing of deposits. The first set (A) is related to a moderate recession with rising inflation and interest rates, and the second set (B) to a global recession with persistently high inflation and rising interest rates.
Figures 7 and 8 depict the two sets of conditions for 10yr-Treasury yield and CPI, denoted as ExplorA and ExplorB. The two figures also illustrate the stark difference in interest rates and inflation between the exploratory analysis and the DFAST severely adverse scenario.
Figures 9 – 14 compare the two sets of conditions, A and B, with the baseline and severely adverse scenarios along the six macroeconomic factors. Set A conditions, denoted as ExplorA in the figures, form a moderate recession, albeit with higher interest rates and inflation compared to the baseline scenario. It is worth noting the relatively higher drop in CRE price index compared to house prices under these conditions.
The recession from the severe economic conditions of set B, denoted as ExplorB, is very similar to the DFAST severely adverse scenario despite the significantly higher interest rates and inflation of set B. There is just a small delay of 1-2 quarters in the trough of Real GDP and peak of Unemployment rate in ExplorB compared to the severely adverse scenario.
The severe conditions of set B seem to be more stressful overall than the DFAST severely adverse scenario. This is because banks would face not only high loan losses as in the standard severely adverse scenario, but they would also not benefit from the effects of falling rates on their securities holdings and loan refinancings.
Furthermore, banks would face stresses on the liability side of the balance sheet with higher funding costs as depositors would seek higher yielding investments. These stresses would be compounded by the shift of 20% of noninterest-bearing deposits into time deposits as prescribed by the Fed’s exploratory analysis, further impacting banks’ profitability.
Thus, the exploratory analysis can stress both sides of the balance sheet and can therefore facilitate integrated stress testing.
Concluding Remarks
The above analysis indicates that the DFAST 2024 severely adverse scenario would lead to similar overall loss forecasts compared to the ones reported from the 2023 stress test.
The heightened stress in the CRE price index is an average across CRE asset classes. However, the rising noncurrent ratio for CRE is currently driven by Office, Retail and Lodging. For this reason, the Federal Reserve states in its scenario guidelines: Declines in commercial real estate prices should be assumed to be concentrated in properties most at risk of a sustained drop in income and asset values, such as offices that may be affected by remote work.1
What happens if a bank, for example, has higher concentration in CRE Office, CRE Retail and/or in urban centers that have been hit more by the changes in consumer behavior? In such cases, as previously argued3,5, a bank should use scenarios for more granular CRE indices by asset class and geography for better accuracy in its loss forecasts and impact on capital. Of course, such granular scenarios should be conditional on the DFAST severely adverse scenario of the aggregate CRE index for consistency.
Similarly, what if a bank, for example, has significant exposures in, manufacturing, oil & gas or agriculture? For its stress test program, the bank should use granular scenarios by industry and geography and for commodities that are consistent with the DFAST severely adverse scenario.
The regional bank crisis of last spring and the ongoing liquidity challenges that some regional and community banks have been facing due to high interest rates have revealed the drawbacks of regulatory and company-run stress testing. The exploratory analysis introduced by the Fed with this DFAST release is a step towards resolving these drawbacks and enabling a bank to perform integrated stress testing. It should therefore be adopted by regional and community banks regardless of their size.
Of course, to create relevant scenarios for integrated stress testing, a bank would have to adapt the exploratory analysis to its geographical footprint and balance sheet mix.
For example, CRE loans account for a substantial portion of bank assets, about a quarter of assets for an average bank. Regional and community banks are particularly vulnerable as they are almost five times more risk exposed to the sector than larger banks. What would happen when half of the uninsured deposits leave the bank if it had to deal with significant losses in its CRE portfolio? Such scenario adaptation is a crucial step that we follow for our clients given their balance sheet composition and geography.
References
- Federal Reserve Board – Federal Reserve Board releases hypothetical scenarios for its 2024 bank stress tests
- Speech by Vice Chair for Supervision Barr on stress testing – Federal Reserve Board
- Karakoulas G., How Company-Run and Fed DFAST Projections Measure Up. RMA Journal, October 2023, pp.15-18.
- https://www.linkedin.com/posts/grigoris-karakoulas-94209b71_speech-by-vice-chair-for-supervision-barr-activity-7121143555414245378-Ppst?utm_source=share&utm_medium=member_desktop.
- 2023 Stress Testing Scenarios | InfoAgora
Grigoris Karakoulas is the president and founder of InfoAgora (infoagora.com) that provides risk management consulting, predictive risk analytics, price optimization, scenario generation and CECL/integrated stress testing solutions, and model validation services. Contact him at grigoris@infoagora.com