Although some of the implementation details differ, the SCAP and DFAST/CCAR supervisory stress tests made broadly similar assumptions on these issues. The guiding assumption is that a bank’s balance sheet and the nature of its exposures do not change over the stress test horizon. The supervisory estimates do not embed behavioral responses to the stress scenario, including additional risk mitigation or changes in business strategy. 11 Further, maturing positions are assumed to be replaced on a like-for-like basis, maintaining the overall credit characteristics of the starting-date portfolios.12 Importantly, banks are assumed to maintain credit supply even as economic conditions in the hypothetical scenario deteriorate. This is a policy judgment reflecting the objectives of the supervisory stress test regime.13 The implication of these choices is that the stress test results are conditional not just on the stress scenario but also on the policy choices embedded in the exercise, rather than being an historically unbiased projection of banks’ behavior under stressed economic and financial market conditions. These assumptions have been implemented in different ways in different supervisory stress test exercises: in SCAP, the balance sheet was assumed to be fixed over the stress test horizon; in the recent DFAST and CCAR stress tests, supervisory models have been used (these models actually tend to result in growth in the balance sheet over the stress test horizon)14 ; and in the currently proposed Stress Capital Buffer (SCB) approach, the balance sheet would once again be held fixed. My discussion thus far has focused on what the stress tests measure.
We are not there yet. Banks’ equity capital accounts for 6 per cent of total assets. This is low from a historical perspective, but not compared with banks in other countries. Banks are procyclical. They amplify business fluctuations. During an expansion, loan losses are low and bank earnings increase due to higher turnover. Capital is readily available. During a downturn, bank losses increase, and earnings and access to equity capital may deteriorate, forcing banks to tighten lending. Norwegian banks need more capital in the period ahead to enable them to absorb expected and any unexpected losses and to satisfy tighter counterparty capital requirements. The government’s offer to supply core capital through the Government Finance Fund will now allow banks to improve their financial strength without rationing credit. There must be no doubt that the banks have the capital they need. The measures I have discussed have been implemented to lessen the effects of the financial crisis. Another question is which lessons we can draw. The authorities in many countries are now working towards increasing the robustness of financial markets. Four points stand out. First, for a given risk assessment, banks must be subject to higher equity capital requirements. Banks calculate their capital requirements based on internal risk models. The models capture historical loan performance. The capital requirements are determined by the degree of credit risk exposure as derived from this historical performance. One drawback is that the historical basis for the models, and hence for the risk assessments, is too limited.