But there is a second set of design choices about how the stress scenario impacts will be modeled. To begin, capital ratios are measured separately for individual institutions, with no attempt to capture dynamic 3/8  BIS central bankers' speeches  interactions, spillovers or specific cross-firm exposures. Similarly, outcomes for the banking sector do not interact dynamically with the macroeconomic scenarios, which are inputs to the calculations. As a result, the calculations are “stand alone” in the sense that the outcomes for any individual institution are independent of those for others in the set of stress-tested firms. Results for the banking system are therefore simply the sum of results for individual institutions, rather than capturing interactions among them. The stand-alone approach reflects the microprudential objectives of the various U.S. supervisory stress test programs, along with practical considerations. While the SCAP and CCAR/DFAST stress tests programs have strong macroprudential elements15 , in each case the results have also been used to make firm-specific supervisory judgments about capital adequacy. This individual firm application pushes towards measurement approaches that capture more detailed, firm-specific characteristics. At the same time, fully dynamic models that capture interactions and exposures among firms or that build in feedback from banking sector outcomes to the macroeconomic scenario can be informationally demanding, computationally intensive and, at the stage of model development prevailing during the SCAP and early phases of the CCAR/DFAST regime, generally would have involved higher level, “industry average” assumptions about the performance of banks under the hypothetical stressed conditions.
The Basel countercyclical capital buffer is the primary supervisory tool to implement regulatory capital requirements that vary over the credit cycle, but stress testing has cyclical elements as well. Both stress scenario design and the starting condition of banks’ balance sheets – the credit characteristics of the loan and securities portfolios, the extent of currently non-performing loans, exposures from trading and counterparty positions – can result in differences in stress test severity over the cycle. What is the optimal degree of cyclicality for the stress testing regime? How does cyclicality of stress testing interact with other cyclical elements, such as the countercyclical capital buffer and the incoming current expected credit loss (CECL) approach to loan loss provisioning? How should the piece fit together? Finally, one concern that has been raised about the Federal Reserve’s approach to stress testing and integration into the CCAR program is that of “model monoculture” – the idea that banks will be incented to develop models that mimic the Fed’s models rather than developing their own independent approaches.17 Significant commonality in modeling approaches in the banking system could result in banks adopting similar risk exposures and hedging techniques, exposing the sector to additional systemic risk and potential future instability. How do we measure this risk? What should we think about differences (and similarities) between bank-generated and supervisory stress test results, both for a particular stress test cycle and over time?