Last month, the Federal Reserve Board published proposed refinements to its annual Comprehensive Capital Analysis and Review (CCAR) exercise—the supervisory stress test that evaluates the capital adequacy of the largest U.S. banks (34 in the 2017 test). In our view, the Federal Reserve has an effective framework for carrying out these all-important stress tests. Having started in 2011, the Fed is now embarking on only the seventh CCAR exercise. That means that everyone is still learning how to best structure and execute the tests. The December proposals are clearly in this spirit.
With this same goal in mind, we make the following proposals for enhancing the stress tests and preserving their effectiveness:
--- Change the scenarios more aggressively and unexpectedly, continuing to disclose them only after banks’ exposures are fixed. --- Introduce an experimental scenario (that will not be used in “grading” the bank’s relative performance or capital plans) to assess the implications of events outside of historical experience and to probe for weaknesses in the system. --- As a way to evaluate banks’ internal models, require publication of loss rates or risk-weighted assets for the same hypothetical portfolios for which the Fed is disclosing its estimates. --- Stick with the annual CCAR cycle....
Securities lending (SL) is one of the less-well-publicized shadow banking activities. Like repurchase agreements (repo) and asset-backed commercial paper, SL can be a source of very short-term wholesale funding, allowing a shadow bank to engage in the kind of liquidity, maturity and credit transformation that banks do. And, like other short-term funding sources, it can suddenly dry up, making it a source of systemic risk. When funding evaporates, fire sales and a credit crunch follow.
Indeed, SL played a supporting role in the 2007-09 financial crisis, being partly responsible for the collapse of the large insurance company AIG when the market seized in September 2008 (see chart). While SL has not garnered the attention of capital and liquidity regulation or central clearing, or even repo markets, it is still worth understanding what securities lending is and the risks it poses. That is the purpose of this post...
