Fed’s Quarles says stress testing innovations helped steer banks through Covid-19 crisis

Innovations in stress testing enabled the Federal Reserve and financial services industry to adapt and respond quickly to the Covid-19 crisis, according to Randal Quarles, vice chair for supervision at the Federal Reserve.

In a speech given at the Federal Reserve Bank of Atlanta in Atlanta, Georgia, Quarles said that analysis provided by the stress test allowed it to tailor its actions “to the risks we faced” during the pandemic.

“We responded to that abrupt change in environment by adapting stress testing to conduct a sensitivity analysis, an application of the stress testing models used to inform the Board of Governors about risks to bank solvency during those rapidly changing conditions,” he said.

“The sensitivity analysis we conducted was possible because we routinely collect standardized data from banks on their exposures and have developed our own loss and income models at the Fed. Thus, we were able to conduct this analysis purely internally, without putting additional burdens on banks during an already-difficult time.”

The central bank’s sensitivity analysis included three additional scenarios that reflected the potential economic implications of the Covid-19 event.

Quarles said that as a result of the measures taken by the Fed and the banks, US bank capital levels increased last year “despite substantial increases in loan loss reserves”, the funds that banks set aside to cover expected losses.

The aggregate common equity ratio across large banks increased from 12% at the end of 2019 to 12.8% at the end of 2020, while over the same period, large banks built approximately $90 billion in loan loss reserves.

The Fed placed a temporary limit on bank dividends for the third quarter of 2020 and also banned share buybacks for the third quarter.

Stress testing of banks was introduced in the wake of the 2008-09 Global Financial Crisis as a way to measure their health and resilience during an economic downturn.

In his speech, Quarles said that the stress testing regime “gave us an urgently needed tool to measure how much additional capital banks with mounting losses needed to survive the financial crisis more than a decade ago”.