…or the Value of Stress Testing

Here’s an easy way to consider the possible value of bank regulation and risk management for credit. Bank charge-offs, like the red and blue line, tend to include relatively long periods of calm with low losses, punctuated with of high losses–”good” times and “bad” times, respectively.

With this as a foundation, then risk management and regulation may:¹

1. Reduce losses in good times.
2. Extend good times/delay bad times.
3. Reduce losses in bad times.

Historical CRE charge-off rates illustrating periods of good times and bad times

1. Does Regulation or Risk Management Enhance Good Times?

Notice that in the graph above, which is illustrative of many credit portfolios, losses in good times tend to be in the single basis points.² Heck, during some quarters net losses are even negative—when recoveries are greater than previously anticipated. In good times, for many portfolios, there isn’t much need for risk management any more than a decent swimmer needs a life jacket in a pool or while floating down a lazy river.

The contentious reader may argue that we’re missing the point and bank regulation keeps losses low in good times, but, from our experience, it seems a challenge to lose money when the economy is humming along…unless you’re particularly foolish.³ In those situations, regulators may save the foolhardy, but at a cost of not providing fresh examples and cautionary tales for everyone else. If regulators and risk managers do reduce idiosyncratic risk in good times—and if that’s all they do—it’s unlikely that the effort and cost are worthwhile.

So, if regulation doesn’t decrease losses (much) in good times, does it help by either delaying the onset of bad times or mitigating losses in bad situations?

Minimal effects of regulation during good times

2. Does Regulation or Risk Management Delay Bad Times?

It is difficult for banks to delay bad times—individually and collectively. It may be possible for the Fed to do so through regulation, but the Fed can take more direct actions—say, via interest rates—to attempt to stimulate economic activity and keep the good times rolling.³ Analogously, fatal, multi-car pileups on the interstate highway speed limit can be almost completely eliminated with 5 MPH speed limits but that would come at a cost of making the highways not worth building as well as probably increasing road rage fatalities.

Bad times will arise. Obviously, there are exogenous shocks, like terror attacks and droughts, that can’t be prevented, and unfortunately, there are endogenous shocks that—when the Fed and politicians forget their Hippocratic Oaths, and as we’ve recently seen—snatch defeat from the jaws of victory. However, delaying bad times via regulation or risk management without destroying the activity, itself, seems a tall task.

Note that there is also the risk that attempting to delay bad times might increase the severity of losses in bad times. (One example is when central bank activities exacerbate bubbles.) Moreover, using our swimming analogy, we don’t think it’s wise to tell folks that they can swim better without life jackets, especially when everyone see rapids ahead, (and especially when a perfectly acceptable portage (or off-ramp) exists).

The challenges and risks of delaying bad times

3. Can Regulation or Risk Management Soften Bad Times?

If regulation (or risk management) doesn’t provide much of a benefit in good times and doesn’t delay the onset of bad times, then in our framework, its only remaining value is to decrease the severity of adverse consequences in bad times.⁴ Mitigating this systematic risk, which, by definition, all banks face, seems to be the most important task for regulators.

We think there is room for improvement.

Potential for regulation to reduce losses during bad times

So, What Are You Going to Do About It?

Risk management is:

• Asking what could go wrong,
• Estimating what could be lost if the bad situation occurs, and
• Deciding, today, what to do about it— through either immediate or contingent actions—to reduce those potential losses.

Immediate actions either (a) reduce the likelihood of a bad event occurring or causing harm—e.g.., prevention activities—or (b) mitigate losses if the event does occur, e.g., via insurance. Contingent actions don’t affect upfront probabilities of the bad stuff happening but do involve plans, or more precisely, policies and procedures that determine how to act should the harm arise. (That’s why you practiced fire drills in school.)

Risk Management versus Compliance

Some years ago, we listened to a conversation between a lead regulator and a senior bank manager that went like this:

At the time, we thought the solution was simple: implement a contingency plan, or write, follow, and commit to credit policy and procedures that stated “if certain macro-economic variables or portfolio characteristics or performance measures break certain thresholds, we’ll stop/reduce/review making new loans, cut lines, whatever.” It seemed rather obvious, but…

Alas, what the managers heard—and perhaps what the regulator implied—was “they want us to show large losses,” i.e., replicate Crisis-level loss rates, and they were off to the races…⁵

We do think regulators had/have a penchant for their supervised banks to show relatively large forecasted losses (as proof that the banks’ pro forma financial statements map to acceptable capital ratios), but in a crisis it’s never about capital.

In that regard, we think the supervisors blew a great—possibly a once-in-a-lifetime opportunity—to more closely tie regulatory stress testing to actionable risk management. (This doesn’t hold for the largest banks—the SIFIs—where stress tests are appropriately tied to risk appetite statements, et. al., but it does for smaller firms.) Smaller firms might hear, “Oh, you might have to adjust your capital plan if some ratio is below some threshold,” but the contingent plans seem to revolve around answering, “how would you adjust your capital plan?”

That seems to be missing the point. Rather than asking, “how can you live with these losses,” we think the Fed should ask, more directly, “how can you prevent or mitigate losses if bad stuff, like this scenario, begins to unfold so you don’t have to live with the losses?”

In this regard, a bank that simply complies with its regulator(s) is also missing its best chance of being prepared for the inevitable downturn.⁶

Conclusion

In sum, we think that regulators and banks are wasting excellent and obvious opportunities to prevent and/or mitigate potential losses—especially given that the marginal cost of the third step of risk management is relatively low compared to the second step, which involves estimating losses via fairly expensive models and stress testing platforms.

As you can see below, after charge-off rates exceeded their good-time levels, balances continued to grow for 18 months at the same rate as in the past, and as everyone who does commercial loss forecasting knows, charge-offs tend lag defaults by about a year, on average, which means that defaults were increasing at least two years before balances started to decrease.

At the start of a downturn, portfolio performance might not be known by scenario providers; so, those scenarios might be rosier than bankers know they should be. At such times, prior to processing models, banks, via their economic forecasting committees (or their equivalents), should adjust scenarios downward. Alternatively, after generating the modeled results, qualitative adjustments to increase forecasted losses can be made by using recent trend information. Banks shouldn’t stop there; they should take advantage of the early warning and act. There is an opportunity cost to tighter credit if events turn good, but that’s the cost of avoiding possible ruinous losses.

Historical relationship between CRE balances and charge-off rates

We’ll have more to say about this soon, but in the meantime note that while employment is part of the Fed’s dual mandate, the Fed seems to overemphasize unemployment as a predictive variable for both C&I losses and CRE losses: by definition, correlated but lagging doesn’t provide an early warning, and, therefore, doesn’t help with risk management.)

At Spero Risk, we create value by intersecting business and modeling silos—by adding quantitative discipline to the business side and business discipline to modeling.

Even the best swimmer needs a life jacket sometimes. After the speedboat crash or while you’re tumbling down the Class 6 rapids that follow the nice, calm, lazy, clear pool, it might be too late to grab one, and it sure seems that the near time will be less calm that it could be.

Finally, for the love of the Lord and all that is sacred, if you’re a politician, please, please, please follow Mark Knopfler’s advice, and Don’t Crash the Ambulance.

Intersection of business and modeling silos