For those interested in a real-life case study of such an outcome, I recommend a paper by Scott Frame, Kristopher Gerardi and Paul Willen about the stress test models used by OFHEO, the agency that oversaw Fannie Mae and Freddie Mac before the financial crisis.7 The paper documents the large understatement of the agencies’ credit risk exposures stemming from “hard coded” models that failed to capture innovation in mortgage underwriting. In fact, the Fed has proposed additional disclosures about its stress test models, including indicative loan loss rates and loss results based on standardized portfolios.8 These enhanced disclosures aim to provide greater insight into the Fed’s modeling approaches and thus to facilitate “peer review,” while maintaining the rigor of the stress testing regime. This is another area where academic economists can help enrich the debate. There is already a literature on the impact of the disclosure of supervisory stress test results;9 that literature could usefully be extended to consider the impact of underlying model disclosure, especially in the context of macroprudential goals. Clear and Predictable Goals and Actions The final element we identified supporting the macroprudential goals of the SCAP was that the exercise had clear and predictable objectives and actions. Our paper argued that the financial crisis environment gave the SCAP a very clear goal of providing confidence that the banking system could continue to lend even under more dire economic conditions as a way of mitigating the chance that those dire economic conditions actually materialized.
Structural macroprudential objectives motivate regulatory tools such as additional capital requirements for systemically important banks (“SIFI surcharges”), which aim to reduce the probability that a large institution fails, and resolution and recovery planning, which seeks to limit the damage in the event of failure. The second set of macroprudential objectives are cyclical objectives, focusing on the build-up of risks during credit and asset price booms and the consequent pull-back in financial intermediation during periods of stress. Cyclical macroprudential goals motivate regulatory and supervisory tools that “lean against the wind” in good times and “lean into the wind” during stress, such as the countercyclical capital buffer, the design of stress test scenarios, and time-varying loan-to-value restrictions, which are imposed in some countries. The macroprudential objectives of the SCAP reflected both structural and cyclical concerns. The primary goal was to ensure that large banks had sufficient capital to withstand an even-worsethan-expected economic downturn and still be able to lend—a structural perspective. Each of the 19 banks was required to raise additional capital if the stress tests indicated a shortfall relative to the supervisory target. However, the SCAP’s objectives also embodied cyclical concerns, namely, to provide confidence that banks could continue current lending (“leaning into the wind”) and thus reduce the likelihood of a worse-than-expected economic outcome. In the paper, we identified six elements that we argued made the SCAP a successful macroprudential exercise: comprehensiveness; consistency; multiple, independent estimates; diverse perspectives; transparency of process and results; and clear and predictable goals and actions.