Barr: Fed to use exploratory scenarios, market shocks in stress tests

The Federal Reserve is developing “both exploratory macroeconomic scenarios and exploratory market shocks” for use in next year’s stress tests, Fed Vice Chairman for Supervision Michael Barr announced today. This builds on last year’s inclusion for the first time of the exploratory market shock component, which was characterized by a less severe recession with greater inflationary pressures.

Barr noted that the exploratory scenario “would not be used to set a firm’s stress capital buffer requirement. Instead, the exploratory scenarios will be used to inform the board’s supervisory assessments of firms’ risk management and our understanding of different risks in the banking system.” The additional scenarios would also provide bank supervisors with additional insight into firms’ internal risk management practices and allow for more creativity in scenario design, he said.

“The use of stress scenarios and shocks that do not set a firm’s stress capital buffer requirement can provide room to explore a wider range of vulnerabilities to inform risk-based supervision,” Barr explained. “For example, if the purpose of the exploratory scenario is to inform the board or the public about new or underappreciated risks, the board could explore the impact of a scenario using a different set of variables than the ones it has currently defined in its policy statement.”

He added that the supervisory stress tests are not a replacement for a firm’s own risk management or internal stress testing processes. “Large banking organizations should maintain a solid line of sight into their own risks and focus their efforts to capture those risks and determine capital need,” he said. “Our stress test is designed to provide a consistent measure of risk across firms, and is not a replacement for comprehensive modeling, risk management and capital planning by the largest banks that enable them to measure and manage their own unique risks.” Barr did not specify how many additional scenarios would be included in the next stress test exercise.