Stress Testing Made Easy: No More US Banks Stumbling and Facing Public Embarrassment Due to

the Federal Reserve’s Qualitative Objection

Dr. John Taskinsoy a

ABSTRACT

The worst two financial crises in human history were in some ways attributable to the US Federal
Reserve’s misguided monetary policies. Many economists share the view that the Fed’s tight-money
policy in the late 1920s caused a significant drop in the money stock (i.e. severe contraction) which
triggered the 1929 stock market crash and the subsequent Great Depression – the worst financial
catastrophe of the 20th century. Close to a century later, the Federal Reserve was on the scene again,
this time economists argue that the Fed’s expansive monetary policy since the late 1990s created an
easy-credit environment (global dollar glut) which induced banks to expand credit into sub-prime
segment turning ordinary folks into avid buyers (i.e. asset-price boom). Consequently, the Fed’s policy
errors along with unfolding contributing and driving forces led to the 2006 mortgage debacle in the
U.S., subsequently an ordinary looking recession was turned into the inevitable 2008 global financial
crisis (GFC) – the worst financial catastrophe of the 21st century. The Trump administration wants
to reverse the bank regulation rules that were put in place following the GFC; last time, President
Clinton repealed the Glass-Steagall Act of 1933 by signing into law the 1999 Gramm-Leach Bliley Act,
which fostered the boom-and-bust of the dot.com and housing bubbles, and the eventual GFC. The
crises in the new millennium have cost investors over $30 trillion and pushed millions of people into
poverty. Stress testing, a simulation technique used by individual banks, supervisory community, and
central banks to safeguard financial stability, has evolved to become a crisis-management tool. Stress
testing is neither a standalone tool nor an early-warning mechanism, but it is indispensable in the
macroeconomic toolkit when used as a complement not a supplement to other tools such as VaR. To
ease up the rules of regulation that was put in place after a near financial meltdown in the U.S. would
be a fatal mistake by the Trump administration, even if the goal is to favor US’ largest banks.

Keywords: Stress Test; Qualitative Objection; Federal Reserve; Macroprudential; Microprudential

JEL classification: C53, E37, E44, E47, E58, G01, G21, G28

 This research did not receive any specific grant from funding agencies in the public, commercial, or not-for-profit sectors.
a
Corresponding author email address: johntaskinsoy@gmail.com
Faculty of Economics & Business – Universiti Malaysia Sarawak (Unimas), 94300 Kota Samarahan, Sarawak, Malaysia

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1.0 Introduction

Stress testing1 is a simulation technique (asking a series of “what if” questions) artificially employed
by humans or powerful computers and has the utmost objective of identifying and gauging strengths
as well as vulnerabilities (to endogenous and exogenous shocks) of an asset, a portfolio, or the entire
banking system under exceptionally adverse market conditions (i.e. extreme but plausible scenarios).
Although stress testing was an arcane topic in the 1980s, it has evolved to become a central focus to
ensure banking stability in the 1990s (especially following the Asian crisis of 1997-98); but since the
2008 global financial crisis (GFC), macroprudential stress testing has become an indispensable crisis-
management tool when used as a complement to stressed value-at-risk (VaR) models.

Even though the use of VaR models had gained enormous popularity2 after the 1987 US stock market
crash, VaR is not a new model at least in theory; Baumol (1963) first introduced the concept in the
early 1960s. Despite VaR’s inherent deficiency to measure risk exposures under financial distress, it
still quickly became a universally accepted standard to quantify market risks in a single number (see
Berkowitz & O’Brien (2001); Fallon (1996); Hendricks (1996); Hull & White (1998)). However two
key decisions were crucial in VaR’s widespread adoption; 1) not only JP Morgan created a benchmark
open architecture called “RiskMetrics”, but provided public access to its compiled database on the
variances and covariance of different asset classes (JP Morgan, 1996); 2) Despite VaR being blind to
certain risks under extreme but plausible scenarios (Danielsson, 2000), it still became the mainstay
when the Basel Committee required banks to use VaR models internally to calculate capital adequacy
and capital requirements for counterparty credit risk and market risk (BCBS, 1996a; b).3

Due to its limitations and constraints, VaR is not a standalone tool to measure market risk (e.g. Jorion,
2001); therefore, numeric outputs of VaRs are less reliable under adverse market conditions and
must be confirmed by a statistical tool4 such as stress testing. Although banks vary substantially in
their uses of VaR, virtually all VaR models (e.g., variance-covariance, historical and Monte Carlo
simulations) focus on the tail-risk which is the lower quantile of distribution of the P&Ls and answer
the question of the largest potential loss over a specified time horizon (t) at a confidence interval (p).

1 Stress testing is new in finance, but it has been used in other disciplines such as civil engineering, architecture, component
engineering and manufacturing, and to test durability and longevity of materials.
2 Bank executives and risk managers were interested in answering the following popular question; “what would be my

maximum loss if the equity markets crash tomorrow more than 10%, 20%, or x%?”
3 The Basel Committee developed a framework just prior to the Asian crisis for “...incorporating backtesting into the internal

models approach to market risk capital requirements” (BCBS, 1996b). On account of deficiencies and imperfect signals
generated by backtesting (Campbell, 2005), stress testing became a mainstay when the Basel Committee required banks
with substantial trading to use stress testing to confirm the accuracy of Value-at-risk (VaR) outputs.
4 Parametric models of volatility, such as ARCH–autoregressive conditional heteroscedasticity was introduced by Engle

(1982); EGARCH (Exponential Garch) by Nelson (1991), and Generalized ARCH (GARCH) by Bollerslev (1986).

2
As mentioned previously, the advantage of VaR is that it aggregates portfolio related losses in a single
number. The largest value-at-risk can be written as 1 - p; in other words, say the VaR on an asset is $1
million for a day at 99% confidence level means that out of trading days there is only 1% chance that
the value of the asset or portfolio will drop more than $1 million in a given one day (see Benninga &
Wiener (1998); Campbell et al. (2011); Dominguez & Alfonso (2004); Lopez & Walter (2000)).

Until the Basel Committee on Banking Supervision (“the Basel Committee”) released Basel I accord to
banks within G-10 in July 1988 (BCBS, 1988), G-10 banks’ capital adequacy calculations were varied
and disparate, which made it extremely challenging for regulators and supervisors to assess whether
each bank had both sufficient capital and adequate capital buffers to withstand shocks. Furthermore,
internationally active banks had constant propensity to invent loopholes5 to circumvent regulation
and banking supervision. Contrary to most expectations, not only Basel I failed to reduce competitive
inequalities and strengthen global banking resilience, but its risk insensitive rules (Table 1) ushered
greater risk-taking by inducing banks to move risky assets between on-balance and off-balance sheets
via securitization (Blundell-Wignall et al. (2014); also see Ferguson (2003); Rodríguez (2002)).6 At
this background, the Basel Committee was prompted to fix deficiencies of Basel I by introducing a
“revised framework” – Basel II in June 2004 (BCBS, 2004) (in effect by January 1st by 2006).

Under Basel II, the capital definition remained unchanged, but was made more risk-sensitive. Basel II
promoted strengthened global banking via three pillars; pillar 1: minimum capital requirement; pillar
2: supervisory review process; and pillar 3: market discipline (BCBS, 2004). While trying to improve
deficiencies of Basel I, Basel II created its own unique problems that fostered developments leading
to a near financial meltdown in the U.S., quickly engulfing countries across the world (i.e. sovereign
debt crisis). The Basel Committee’s plans did not work exactly as envisaged; banks’ heavy reliance on
ratings by external credit assessment institutions (ECAIs) instigated a “cliff” effect in capital minima
which played a crisis-intensifier role before, during, and aftermath of the GFC (BCBS, 2010). In stark
contrast to a popular view, Caruana (2010) contends Basel II is the main architect behind the GFC for
two reasons: first, the GFC manifested itself on the basis of endogenous and exogenous factors (Fed’s
expansive monetary policies and the resultant dollar glut) several years prior to the implementation
of Basel II; secondly, the majority of countries that adopted Basel II did so in 2007 or later than GFC.

5 Loopholes such as skirting, race to the bottom, de facto versus de jure and cherry picking. Each of these methods involved
expanding bank operations into countries where banking regulation/supervision is weak or relocating to countries where
banks are subject to less rigorous capital and liquidity requirements.
6 Ferguson (2003) said “Basel I accord is too simplistic to adequately address the activities of the most complex banking

institutions”. Jones (2000) argues that Basel I caused leverage and arbitrage, Jackson et al. (1999) claim that capital minima
under the Basel I is another taxation. Elizalde (2007) argues that arbitrary rules of Basel I caused credit crunch in the
1990s. Taskinsoy (2013a; 2013b; 2018a; 2018b) examines effects of Basel Standards in Turkey and ASEAN-5.

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Table 1: Credit Assessments and Corresponding Risk Weights under Basel I, II & III

Basel I Accord
Basel I risk weights and categories of on-balance sheet asset

Cash claims on OECD governments and loans either collateralized or and guaranteed by them,
1. 0%
claims on non-government domestic entities.

Claims on multilateral development banks incorporated within OECD and loans guaranteed by
2 20%
such entities, cash in collection, claims on OECD banks and short-term loans (less than one year).

Fully secured first lien mortgage loans on residential properties either occupied by the
3 50%
borrower or rented out.

Claims on private sector, non-OECD banks (maturity of over one year), commercial firms owned
4 100%
by public entities, non-OECD governments, real estate, and equity issued by banks.

Basel II – Revised Framework

Sovereign Credit Assessment and Risk Weights

Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated

Risk Weight 20% 50% 100% 100% 150% 100%
Financial Institutions and Corporations
Credit Assessment AAA to AA- A+ to A- BBB+ to BBB- BB+ to B- Below B- Unrated
Risk Weight 20% 50% 50% 100% 150% 50%
Short-Term Risk Weight 20% 20% 20% 50% 150% 20%
Corporate 20% 50% 100% 100% 150% 100%
ECA Risk Scores 0-1 2 3 4-6 7
Risk Weight 0% 20% 50% 100% 150%

Basel III
Phase-in Arrangements

2014 2015 2016 2017 2018 2019

Minimum CET1 ratio 4.0% 4.5% 4.5% 4.5% 4.5% 4.5%
Capital buffer 0.625% 1.25% 1.825% 2.5%
Minimum common
4.0% 4.5% 5.125% 5.75% 6.375% 7.0%
equity + capital buffer
Phase-in deductions
20% 40% 60% 80% 100% 100%
from CET1
Minimum Tier 1 capital 5.5% 6.0% 6.0% 6.0% 6.0% 6.0%
Minimum total capital 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%
Minimum total capital
8.0% 8.0% 8.625% 9.25% 9.875% 10.5%
+ conservation buffer
Liquidity Coverage
Observation Began 2011 Introduce minimum standard by 2015
Ratio (LCR)
Net Stable Funding
Observation Began 2011 Introduce minimum standard by 2018
Ratio (NSFR)
Source: Basel Committee on Banking Supervision (BCBS, 2010)
Notes: The minimum capital requirement increased significantly (4.5% Tier 1 + 2.5% capital buffers). Two new
liquidity standards (LCR > 100% and NSFR > 100%) and a leverage ratio (3%) have been introduced. Further, new
charges (2.5% G-SIB surcharge) and a 2.5% countercyclical buffer apply. When the minimum capital requirements,
capital buffers, and surcharges are added; banks may have as much as 13% capital charge.

4
The GFC revealed that the earlier stress tests conducted by both banks and supervisors were not fail-
safe. Their narrow bank-focused approach was gravely inadequate as it failed to detect new risk types
deeply embedded in securitized derivatives such as structured investment vehicle (SIV) and special
purpose entity (SPE). These innovative financial tools contributed to financial instability and induced
the development of enhanced new-generation stress tests (Jobst et al., 2013). Macro stress testing as
a crisis management tool for the first time was undertaken by the Fed in 2009; the Supervisory Capital
Assessment Program (SCAP) was regarded as informative since it had provided credible and market-
demanded information for the projected post-stress test losses (Fed, 2009a; b).7 The success of SCAP
spurred widespread use of macro stress tests by central banks globally as a crisis management tool.8
In stark contrast to the SCAP, the Committee of European Banking Supervisors (CEBS), succeeded by
the European Banking Authority (EBA), bungled on their first two EU-wide macro stress tests.

Monetarists, postulating that tight-money or expansive monetary policies (i.e. changes in the money
supply) directly affect the economic activity (i.e. prices, GDP, and employment), infer that the causes
of the Great Depression of the 1930s and the GFC of 2008 had much in common (Friedman & Schwartz
(1963); Bernanke and Gertler (1995); Eichengreen (2002)). Prior to the Great Depression, the Fed’s
misguided and unjustified tight-money policy errors in the late 1920s resulted in a substantial drop
in the money stock (i.e. severe contraction), which led to the 1929 stock market crash, recession, and
inevitable Great Depression. A chorus of economists hold the belief that the Fed’s untimely monetary
tightening amid deflationary9 environment was unwarranted since the macroeconomic conditions of
the era had not awaken subdued inflation (Bernanke (2004); Friedman & Schwartz (1963)). Epstein
and Ferguson (1984) in defense of the Fed’s tight-money policy action claim the Fed’s main objective
was to curtail speculation on Wall Street (bubble); conversely, the Fed gravely failed in its objective
and left the economy debilitated. According to Crockett (1997), a normal-functioning economy relies
on both monetary stability and financial stability (i.e. integral components), Borio (2003) calls it “twin
stability”. Prior to the GFC of 2008, this time the Fed’s prolonged accommodative monetary policies
resulted in global dollar glut (cheap dollar), this in turn induced banks to expand credit into riskier
mortgage segment such as sub-prime (i.e. some lenders engaged in predatory lending). All of these
factors and more caused the outbreak of the GFC which was a near financial meltdown in the U.S.

7 The SCAP stress tested 19 bank holding companies (BHCs), each of which with a combined total assets of $100 billion or
more at year-end 2008. These 19 BHCs (SIBs) have controlled nearly 70% or two-thirds of all assets in the U.S. banking
system and collectively owned more than 50% of every loan type generated in the banking sector which is consistent with
other advanced nations. The duration of the SCAP was two years, covering 2009 and 2010.
8 In the immediate aftermath of the GFC, macroprudential stress tests were designed and conducted by central banks and

supervisors to assess the resilience of the financial system as a whole plus to develop supervisory assessments of capital
adequacy and adequate capital planning at systemically important banks (SIBs).
9 Mankiw (1997) argues that a moderate deflation can contribute positively to the aggregate money supply.

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2.0 Literature Review

In the financial history of the United States, there have been numerous banking panics, economic and
financial crises, but none of them has left an everlasting deeply engraved agony than Great Depression
of the 1930s and Global (Great) Financial Crisis (GFC) of 2008.10 The two unprecedented events (Big
Bangs11) had required likewise measures to calm the public panic and to restore investor confidence.
In the immediate aftermath of the Great Depression, Wheelock (2007) called it “…by far the worst
catastrophe of the 20th century”, the U.S. as a reactionary response passed isolationist “beggar thy
neighbor” policies12 (see Eichengreen & Irwin (2010); Hall & Ferguson (1998)). Moreover, the Glass-
Steagall Act13 (Banking Act of 1933) was passed, barring US commercial banks from investment bank
activities (Mester (1996); Crawford (2011); Lardner (2009)). The GFC14, the worst catastrophe of the
21th century15, caused unparalleled damage to the US economy and across the world (Blinder (2013);
Gorton (2008); Laeven & Valencia (2008; 2010); Cochrane (2010); Elwell (2010); Labonte (2010)). A
study by Government Accountability Office (GAO) shows that the most recent global credit crisis
(2007-08) in systemic nature cost the U.S. economy alone over $22 trillion.16

Bank failures are traumatic events with a consequence of social upheaval; in that regard, the GFC of
2008 spared no country based on size or economic power; first originated in the U.S., quickly engulfed
adjacent countries (i.e. contagion), and spread to Europe as a sovereign debt crisis (see Acharya et al.
(2014); Ardagna & Caselli (2014); Bellucci et al. (2012); Bulmer (2014); Dyson (2010; 2014); Cramme
& Hobolt (2014); Chang & Leblond (2015); Genovese et al. (2016); Lane (2012); Gocaj & Meunier
(2013)). Due to the GFC’s farfetched economic, financial, and societal implications17 worldwide; stress
testing has evolved from a scenario analysis (a simulation technique used in the early 1990s by banks
for internal risk-management purposes) to a crisis-management tool (used by central banks to ensure
that banks would have sufficient capital to continue lending during an economic downturn). However,

10 For history and a more detailed discussion on Great Depression; see Bernanke (1983), Hamilton (1987), Bierman (1991),
Bernanke & James (1991), Calomiris & Mason (1997), Cole & Ohanian (1999), Hall & Ferguson (1998), Eichengreen
(2003), Meltzer (1976), Temin (1976), Taskinsoy (2019a), and Wheelock (1998; 2010).
11 See Margo (1993) for the metaphoric “Big Bang” inference.
12 Countries passed protectionist policies to resolve their own economic problems at the expense of other nations.
13 It was drafted by Senator Carter Glass and Representative Henry Steagall. The United States raised tariffs further through

the passage of the Smoot-Hawley Tariff Act of 1930.

14 Bernanke (2005) characterized the crisis as “a global financial meltdown”; Blinder (2013) described it as a “perfect

storm”; the IMF said the 2008 crisis was the “largest financial shock since the Great Depression”; and Kapoor (2010)
referred to it as “…the biggest financial crisis in living memory”.
15 The GFC and the resultant unfolding events caused 8 million foreclosures, 9 million lost jobs (unemployment rate spiked

as much as 25%). Households became more indebted, the median households lost 40% of their assets; as a result, between
0.5% and 1% of the world population slipped into poverty (see Beachy, 2012).
16 The IMF estimated the cost of the GFC as $11.9 trillion ($10.2 trillion in the U.S. and $1.7 trillion in developing countries).

https://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-
17 The extent of the GFC’s impact differed between conventional and Islamic banking systems (e.g. Taskinsoy, 2012).

6
stress testing is neither an early-warning mechanism nor a standalone tool (e.g. Borio et al., 2012);
rather, it is a work-in-process which does not attempt to supplant any tool. Quite the reverse, stress
testing is indispensable when used as a complement not a supplement to an arsenal of tools in the
macroeconomic toolkit of central banks. Since the late 1990s, the evolution18 of stress tests has been
influenced by the waves of shocks; Asian crisis (1st wave); the U.S. mortgage debacle of 2006 (2nd
wave); the GFC of 2008 (3rd wave); sovereign debt crisis in eurozone in end of 2009 (4th wave); now
the U.S. – China trade war (since 2018) and its impact on international trade (5th wave).

Until the Asian crisis of 1997, financial institutions mainly used value-at-risk (VaR) models to assess
their potential losses due to risk exposures/concentration (widespread use of VaR models gained
popularity despite its weaknesses following the US stock market crash in 1987 – Black Monday). VaR
is good at quantifying market risks in a single number (Jorion, 2001), but it is blind to certain risks
such as pipeline, securitization, short-term funding liquidity, interbank contagion and counterparty
default under extreme but plausible scenarios (Danielsson, 2000). Virtually all VaR models focus on
downside risks ignoring liquidity and systemic risks; therefore, the accuracy of VaR numeric outputs
depends on previously set variances and covariances19. In spite of VaR’s inherent deficiencies, it still
became a mainstay as part of the 1996 Market Risk Amendment to calculate the regulatory capital
minima and necessary capital buffers for counterparty credit risk and market risk (BCBS, 1996a). But
just like stress testing, VaR is not a standalone tool and the inherent imperfections of the two
approaches become no issue when they are used as a complement to each other (see Fallon (1996);
Hendricks (1996); Benninga & Wiener (1998); Kupiec (1995); Lopez & Walter (2000)).20

In the late 1990s (prior to the homegrown Asian crisis)21, the Basel Committee internally developed
backtesting to validate the accuracy of VaR outputs (e.g. BCBS, 1996b). It was observed that this new
approach to risk management had major flaws, so the Basel Committee stated that it was not settled
on one method to promote further research on the development of more enhanced risk management
techniques. Due to deficiencies and imperfect signals, backtesting was succeeded by microprudential
stress testing (see BCBS (1996b); Campbell (2005)). Microprudential stress testing (bottom-up: BU),
narrow and bank-focused as opposed to broader and system-focused (macroprudential), is employed
by banks for internal risk management purposes which may involve calculating capital adequacy and

18 Risk measurement has evolved as follows: standard model, internal model (VaR), scenario stress testing, stressed VaR,
and reverse stress tests.
19 After the 1987 stock market crash, JP Morgan created a benchmark open architecture called “RiskMetrics” and provided

public access to its compiled database on the variances and covariance across different asset classes (JP Morgan, 1996).
20 GARCH, IGARCH, EGARCH, and the quasi-maximum likelihood GARCH (or QML GARCH) can be used as alternative models.
21 Augmented financial turmoil in the 1990s also prompted the International Monetary Fund (IMF) and the World Bank to

jointly establish the Financial Sector Assessment Program (FSAP) in 1999 to assess financial sector soundness and the
stability of the IMF member-countries (IMF & World Bank, 2003; 2005).

7
making proper capital allocation decisions, and by supervisors for pillar II solvency under Basel II to
assess each bank’s financial soundness and the resilience of banking sectors (for liquidity and stress
testing principles, see BCBS, 2008; 2009a, b).22 Until the GFC of 2008, earlier stress tests conducted
by individual banks and the supervisory community gravely failed to capture complex risk types23
(i.e. SIVs, SPEs, mortgage-backed (MBs), and etc.) entrenched in the financial system; Tarullo (2010)
contends that micro stress tests without rigorous scenarios would provide meaningful results.

The Committee on the Global Financial System (CGFS)24 had surveyed 43 large internationally active
banks/securities firms from ten countries on their use of stress tests. After 424 stress tests conducted
by these firms, the results showed that most commonly used stress testing techniques in 2000 were
simple sensitivity test (which measures adverse impact of changes in a single risk factor, say rising
interest rates or unemployment) and scenario analysis (that measures potential losses under extreme
but plausible scenarios). The CGFS concluded that stress testing was a valuable tool for gauging and
managing risks; moreover, interviewed risk managers demonstrated high commitment to developing
in-house stress tests (for details, see CGFS, 2000; 2001). As a follow-up of the April 2000 survey, the
CGFS initiated another survey (May 2004) on enterprise-wide stress tests; 64 banks and securities
firms from 16 different countries participated (50% more than the 2000 survey). The overall strategic
goal was to observe how stress testing practices had evolved since 2000. The results25 of showed that
interest rate fluctuations and credit risk stress tests took the top two positions (CGFS, 2005).

Following the GFC of 2008, stress testing has evolved26 to become more macroprudential oriented as
a crisis-management tool within the regulatory toolkit available to central banks. This new wave of
stress tests were inaugurated in two continents in parallel; the US Supervisory Capital Assessment

22 The Committee on the Global Financial System conducted extensive surveys on the earlier stress testing practices by large
financial institutions (see CGFS, 2000; 2001; 2005).
23 The Basel Committee observed several areas where microprudential stress tests failed; earlier stress tests concentrated

mainly on credit risk and ignored other important risk types (i.e. liquidity). Stress testing did not involve senior managers
enough in various stages of development and scenario selection. Earlier stress tests were narrow scope and bank-focused
bank-wide aggregation of stress test results was nonexistent. Stress scenarios lacked rigor and correlations of impacted
results, which mostly focused on potential losses rather and ignored the possibility of funding freeze (i.e. illiquidity).
24 The CGFS is a central bank forum established by the Governors of the G-10 central banks to monitor and examine broad

issues relating to strengths and weaknesses of the global financial markets.

25 60 firms ran 357 stress tests on interest rate movements compared with 174 stress tests on credit default risks by 52

firms). Stress tests on foreign exchange positions (116 stress tests by 45 firms) and equities (130 tests by 49 firms) were
the next two highest applied categories. Only fewer tests were conducted on real-estate bubble risk (18 firms ran 32 stress
tests). As far as the regions are concerned, North America had the highest number of stress tests (186 tests by 48 firms),
35 firms from emerging markets conducted 172 stress tests (second highest). Japan had the fewest stress tests, 15 firms
conducted about 50 tests (Asia excluding Japan, 124 stress tests).
26 The timeline in the evolution of stress testing as follows: in early 1990s, banks began stress testing of trading activities;

in 1996, the Basel Committee introduced Market Risk Amendment to Basel I; in 1999, the IMF and the World Bank jointly
initiated Financial Sector Assessment Program (FSAP); in 2000s, central banks and the supervisory community began to
develop macro stress tests; in 2004, Basel II was introduced and banks were required to stress test credit risk; in 2009,
the Fed undertook the SCAP; in May 2009, the CEBS conducted the first EU-wide stress test; in 2011, the Fed began CCAR
(Comprehensive Capital Analysis and Review (CCAR) programme which incorporates an annual bank stress test).

8
Program (SCAP), undertaken by the Fed in early 2009, was the first prominent example (Fed, 2009a;
b); Europe trailed the Fed, and began inaugural EU-wide stress test in May 2009 (CEBS, 2010a; b).27
Despite SCAP’s success, the Fed replaced it with two fresh stress tests; the Comprehensive Capital
Analysis and Review (CCAR) and Dodd-Frank Act Stress Testing (DFAST)

Source: Federal Reserve (2018)

Figure 1: Capital Ratios of US Largest Banks in Severely Adverse Scenario under DFAST 2018

27 The evolution of stress testing in Europe: Financial Services Authority (UK) released Consultation Paper “Stress and
Scenario Testing” (CP 08/24) in December 2008 and Policy Statement 09/20 “Stress and Scenario Testing Feedback” (CP
08/24) in December 2009 (Bank of England (BOA) began conducting annual stress test in 2009 onward). European
Banking Authority (EBA) began to design and conduct annual EU-wide stress test (2010 – present). The evolution of stress
testing in the U.S: The Fed conducted Supervisory Capital Assessment Program (SCAP) in February 2009 (no stress test
in 2010). Despite the SCAP’s success, the Fed launched two new stress tests; 1) Comprehensive Capital Analysis and
Review (CCAR) between 2011 and 2013; 2) Dodd-Frank Act Stress Tests (DFAST) during 2013-2018.

9
Since 2011, the Fed has been conducting two separate stress tests each year, CCAR (i.e. bank holding
companies (BHCs) with consolidated assets of $50 billion or more) and DFAST (i.e. small community
banks).28 However, the US Congress passed a regulatory relief bill in 2018 which raised the threshold
from $50 billion to $250 billion. In the stress tests between 2013 and 2018, BHCs had to pass both
quantitative (i.e. above threshold CET1 capital ratio) and qualitative measures; the latter was decided
after the Fed’s own assessment. Table 2 shows which BHCs’ capital plans received conditional non-
objection or objection based on quantitative or qualitative grounds. In January 2017, the Fed decided
not to issue qualitative objections for banks with less than $250 billion in assets.

Table 2: Federal Reserve’s Actions on Capital Plans in CCARs 2013-2018

Year Objection to capital plan CET1 % Federal Reserve Comment

Ally’s capital plan was rejected because it failed to meet

the threshold CET1 of 5%. BB&T’s capital plan was
Ally Financial Inc. 1.8
objected by the Fed on qualitative grounds even though
2013
the bank’s CET1 ratio was well above the hurdle CET1
BB&T Corporation 7.8
ratio. Two BHCs were asked to remediate weaknesses
and resubmit a new capital plan to the Fed.

Citigroup Inc. 6.5 Zion’s capital plan received quantitative objection as it

HSBC North America Holdings Inc. 6.6 failed to meet CET1 of 5%. Other 4 BHCs were objected
2014 RBS Citizens Financial Group, Inc. 9.0 based on qualitative grounds and asked to resubmit a
Santander Holdings USA, Inc. 7.9 new capital plan (failure to do so would lead to the Fed’s
Zions Bancorporation 4.4 objection to capital plans/capital distributions).

All three BHCs received qualitative objection to their

Deutsche Bank Trust Corporation
Santander Holdings USA, Inc.
2015
Bank of America Corporation
(conditional non-objection)
34.7 capital plans. Despite Deutsch Bank’s very high CET1
9.4 ratio, the Fed’s analysis indicated major deficiencies
6.8 across the bank in risk identification and measurement.
Bank of America was asked to remediate the observed
deficiencies and resubmit their new capital plans.

All three BHCs received qualitative objection to their

Deutsche Bank Trust Corporation
Santander Holdings USA, Inc.
2016
Morgan Stanley (conditional non-
objection)
30.1 capital plans. Deutsch Bank Trust made improvements
11.9 but the bank still had unresolved supervisory issues.
7.7 Similarly, Santander made progress but had unresolved
supervisory issues. Morgan Stanley was asked to
remediate some issues and resubmit a new capital plan.

Capital One Financial Corporation 5.6 No objection to capital BHCs’ plans based on qualitative
2017
(conditional non-objection) grounds. Capital One was asked to resubmit a new plan.

The Fed issued no qualitative objection according to the

DB USA Corporation 12.2 new regulatory bill passed in January 2017. The capital
The Goldman Sachs Group, Inc. 4.6 plan of DB USA was rejected, other three BHCs failed to
2018
State Street Corporation 4.0 meet minimum post-stress test capital ratios, and were
Morgan Stanley 5.0 asked to remediate issues observed by the Fed and
resubmit new capital plans to avoid objection.

Source: Federal Reserve

28 CCAR (largest BHCs) is submitted to the Fed semi-annually (January and July of each year), whereas DFAST (smaller
banks) is submitted annually (March 1st of every year). As of January 2017, the Fed decided that the capital plans of BHCs
with consolidated assets of $250 billion or more would not be rejected by the Fed based on qualitative grounds.

10
Table 3: Federal Reserve Estimates in the Severely Adverse Scenario
2013 2014 2015 2016 2017 2018
Bank Holding Companies (BHCs)
DFAST CCAR DFAST CCAR DFAST CCAR DFAST CCAR DFAST CCAR DFAST CCAR
Ally Financial Inc. 1.5 1.8 6.3 6.3 7.9 7.1 6.1 5.2 6.5 5.2 6.8 5.5
American Express Company 11.3 5.0 14.0 8.4 15.5 8.2 12.3 6.6 10.6 5.0 7.8 4.4
BancWest Corporation ---- ---- ---- ---- ---- ---- 8.6 9.0 9.1 6.1 ---- ----
Bank of America Corporation 6.9 6.0 6.0 5.0 7.4 6.8 8.1 7.1 8.9 6.8 7.9 5.4
The Bank of New York Mellon Corp. 15.9 13.2 16.1 12.7 16.0 11.4 11.2 8.4 11.2 9.1 9.0 8.3
Barclays US LLC ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 9.6 9.6
BB&T Corporation 9.4 7.8 8.4 8.1 8.1 7.1 6.9 6.1 7.9 6.3 7.9 6.0
BBVA Compass Bancshares, Inc. ---- ---- 8.5 8.1 6.3 6.3 6.5 6.4 7.7 7.4 7.6 7.2
BMO Financial Corporation ---- ---- 7.6 7.6 9.0 9.0 5.9 5.9 8.0 8.0 8.3 8.3
BNP Paribas USA, Inc. ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 7.9 7.9
Capital One Financial Corporation 7.4 6.7 7.8 5.6 9.5 7.0 8.2 6.4 7.0 5.6 5.7 4.6
CIT Group Inc. ---- ---- ---- ---- ---- ---- ---- ---- 12.9 5.4 ---- ----
Citigroup Inc. 8.9 8.2 7.2 6.5 8.2 7.1 9.2 7.7 9.7 8.0 7.2 5.6
RBS Citizens Financial Group, Inc. ---- ---- ---- 9.0 10.7 9.8 8.8 7.7 7.7 6.5 6.8 5.4
Comerica Incorporated ---- ---- 8.6 7.8 9.0 7.9 8.3 6.8 9.4 7.5 ---- ----
Deutsche Bank Trust Corporation ---- ---- ---- ---- 34.7 34.7 30.1 30.1 60.2 58.0 ---- ----
Credit Suisse Holdings (USA), Inc. ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 17.6 17.2
DB USA Corporation ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 12.2 12.2
Discover Financial Services ---- ---- 13,7 8.7 15.3 10.4 12.4 8.7 10.4 6.9 8.9 5.8
Fifth Third Bancorp 8.6 7.5 8.4 7.5 7.9 6.9 6.8 5.9 8.0 6.3 7.5 5.5
The Goldman Sachs Group, Inc. 8.2 5.3 9.2 5.7 9.9 5.8 10.2 7.6 8.4 6.0 5.6 4.6
HSBC North America Holding, Inc. ---- ---- 6.6 6.6 8.9 8.9 9.1 7.0 12.9 8.9 8.1 7.8
Huntington Bancshares Inc. ---- ---- 7.4 6.0 9.0 7.9 5.0 5.6 7.0 6.0 8.1 5.8
JP Morgan Chase & Company 6.8 5.6 6.7 5.5 6.5 5.0 8.3 6.8 9.1 6.9 7.2 4.9
KeyCorp 8.0 6.8 9.3 8.0 9.9 8.5 6.4 6.4 6.8 5.5 6.8 4.6
M&T Bank Corporation ---- ---- 6.2 6.7 7.3 6.9 6.9 4.6 7.9 6.2 7.5 4.0
Morgan Stanley 6.4 5.6 7.6 ---- 8.8 5.9 10.0 7.7 9.4 7.9 7.3 5.0
MUFG Americas Holdings Corp. ---- ---- ---- 5.9 8.0 8.0 10.1 10.2 12.5 11.5 12.2 10.4
Northern Trust Corporation ---- ---- 11.7 10.0 12.4 10.8 9.6 8.7 10.9 9.1 11.7 9.4
The PNC Financial Services Group, Inc. 8.7 8.6 9.0 8.1 9.5 8.0 7.6 6.1 8.0 6.3 6.4 5.3
RBC USA Holdco Corporation ---- ---- ---- ---- ---- ---- ---- ---- ---- 11.2 11.2
Regions Financial Corporation 7.5 7.0 9.0 8.2 8.3 6.8 7.3 6.2 8.2 6.0 8.1 5.2
Santander Holdings USA, Inc. ---- ---- 7.3 7.9 9.4 9.4 11.8 11.9 12.4 12.8 15.2 14.8
State Street Corporation 13.0 9.7 14.7 11.4 14.3 10.8 9.6 6.6 7.4 6.0 5.3 4.0
SunTrust Banks, Inc. 7.3 6.9 9.0 8.0 8.2 7.3 7.5 6.4 7.1 5.4 6.6 4.7
TD Group US Holdings LLC ---- ---- ---- ---- ---- ---- 8.4 8.7 11.3 11.3 11.2 10.6
UBS America Holding LLC ---- ---- ---- ---- ---- ---- ---- ---- ---- ---- 16.4 16.2
U.S. Bancorp 8.3 6.6 8.3 6.6 8.6 7.3 7.5 6.2 7.6 6.3 7.5 6.0
Wells Fargo & Company 7.0 5.9 8.2 6.1 7.6 6.2 7.2 6.1 8.6 7.4 8.6 6.5
Zions Bancorporation ---- ---- 3.6 4.4 5.1 5.1 6.6 6.0 8.5 6.6 ---- ----
Source: Federal Reserve

11
In the 2018 CCAR, a number of BHCs’ CET1 capital ratios fell below the benchmark CET1 of 4.5% (see
Table 3, 2018 CCAR); these BHCs were required by the Fed to take all necessary steps to remediate
issues to comply with the minimum regulatory post-stress test capital ratios. The BHCs in question
made progress to strengthen their capital ratios, their stressed ratios with adjusted planned capital
actions as follow; American Express (4.4 to 5.0), The Goldman Sachs (4.6 to 4.8), JP Morgan (4.9 to
5.0), KeyCorp (4.6 to 4.8), M&T Bank (4.0 to 4.9), and MUFG Americas Holdings (5.0 to 5.9).

The fast rise of cryptocurrencies’ valuations since the birth of first successful cryptocurrency – Bitcoin
in January 2009 (e.g. Nakamoto, 2008) has attracted the Fed’s attention; but their traumatic and even
faster fall since January 2018 has prompted the Fed to consider including a cryptocurrency market
crash scenario as one of the potential risks to take into account when designing and conducting both
micro and macroprudential supervisory stress tests. The recent cryptocurrency price correction since
January 2018 has cost more to investors (i.e. over $700 billion of value evaporated) than the Asian
crisis of 1997-98 which cost investors worldwide circa $600 billion (excluding equities in Japan). The
market cap of over 2,000 digital coins peaked at $830 billion on December 17, 2017 (Taskinsoy,
2018c; 2019b), and price of bitcoin reached intraday high of $20,089 (currently $3,860, a loss of 81%
in value). Unprecedented cost of the GFC to the world’s economies, $22 trillion to US economy
alone (see Blinder (2013); Gorton (2008); Laeven & Valencia (2008))29, has renewed interest
for search of an alternative currency to the U.S. dollar’s hegemony (Taskinsoy, 2019c).

3.0 Concluding Remarks

Stress testing has evolved since the early 1990s to become indispensable when used as a complement
to stressed VaR. After the GFC, macroprudential stress testing has become a central focus as a crisis
management tool to safeguard financial stability. A decade has passed since the SCAP (2009), and the
Federal Reserve is substantially more experienced with stress testing; nevertheless, the evolution of
stress testing will continue because banking operation revolves around a constant inventory of risk.

After a decade has passed since the worst credit crisis in human history, as its panic has completely
receded, the Federal Reserve has signaled its intention of re-structuring its annual stress tests (i.e.
DFAST and CCAR) which are used to gauge capital adequacy (i.e. sufficient capital plus capital buffers
at each BHC) and the ability of the country’s largest financial institutions not only to withstand both
exogenous and endogenous shocks under highly adverse market conditions, but continue lending to

29 The IMF estimated the cost of the GFC as $11.9 trillion ($10.2 trillion in the U.S. and $1.7 trillion in developing countries).
https://www.telegraph.co.uk/finance/newsbysector/banksandfinance/5995810/IMF-puts-total-cost-of-crisis-

12
households and businesses. The Trump administration wants to reverse stress testing rules that were
put in place following the GFC of 2008; however, last time when President Clinton passed the Gramm-
Leach Bliley Act of 1999 to repeal the Glass-Steagall Act (also referred to as Banking Act of 1933)
which was passed following the Great Depression of the 1930s to bar the U.S. commercial banks from
engaging in investment bank activities, the GFC took place in less than a decade after this decision.

It can be said that the Trump administration is moving hastily to ease a flurry of regulations imposed
on the country’s largest domestic BHCs. Many would agree that US financial system is substantially
more resilient since the GFC, but the changes are likely to make it easier again for banks to expand
credit into riskier segments as they did since the late 1990s. Although the Fed’s stress tests of DFAST
and CCAR with consistent results may indicate that many of the recent regulations are onerous and
maybe unnecessary, but reversing them now amid trade war could make the US financial system more
vulnerable to shocks. Financial authorities should never overlook the fact that large internationally
active banks always have the propensity to create loopholes to circumvent regulation/supervision.

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