Many large banks continued to pay dividends well into 2008, even after government support was provided to the banking industry via the Troubled Asset Relief Program (TARP), something noted in the press at the time.2 Some have argued that these continued dividend payments reflected intentional risk-shifting from equity to debt holders,3 though many institutions had stopped making share repurchases months before,4 which does not seem consistent with risk-shifting behavior. Alternatively, in an environment of considerable uncertainty, banks may have been concerned with the negative market signal that a dividend reduction might send, hesitating to be the first to take this step. Supervisory stress testing emerged as a policy solution to address both backward-looking regulatory capital ratios and possible first-mover problems facing banks during periods of stress. 1/8  BIS central bankers' speeches  By their nature, stress tests are designed to ask “what if” in a forward-looking way. Stress tests aren’t a prediction of future events but rather hypothetical exercises intended to assess the robustness of a bank’s resources against various potential future bad outcomes. In this way, they provide additional insight into the true degree of capital adequacy inherent in a bank’s current capital position and the risks embedded in its balance sheet, including its ability to continue to make capital distributions in both baseline and stressed economic conditions.
Bank-specific elements – which, as noted above, are critical to the microprudential policy objectives of the CCAR and DFAST programs – are introduced by using detailed data provided by each participating institution. Thus, results for individual banks vary based on the characteristics of their balance sheet and business focus, but not due to differences in the way particular net income or capital elements are modeled. Other choices are possible, of course, principally the choice to make greater use of bankgenerated stress test results as a way of capturing institution-specific factors, as is done in supervisory stress testing programs in some other jurisdictions. The European stress tests, for instance, are based on estimates made by the participating banks, subject to a variety of constraints on modeling assumptions and detailed review by supervisors.16 What I hope you take away from this review of the what and the how of stress testing is that the SCAP, CCAR and DFAST programs have involved a series of inter-connected design choices, most of which were intended to address the objectives of the stress test exercises, but none of which were inevitable or pre-ordained. Collectively, these design choices have implications for what the stress tests capture, as well as what they miss. I want to share a few thoughts about 4/8  BIS central bankers' speeches  the latter before turning to some suggestions for how additional research could help.