Stress Testing and Shadow Banking

Supervisory stress tests imposed new and burdensome compliance requirements in the immediate aftermath of the 2007‐'09 financial crisis. With time and experience, perceptions have changed.

By 2018, “large financial institutions [had] more than doubled their capital levels since the financial crisis, in part because of supervisory programs like CCAR,” the Federal Reserve Board proclaimed in the executive summary of that year's Comprehensive Capital Analysis and Review report. And David Biegel, head of U.S. stress testing for multinational banking giant HSBC, today takes the not uncommon position that well beyond serving as a compliance exercise that has strengthened balance sheets, stress testing has become an important contributor to financial institution managements' understanding of risk exposures, as well as to general decision-making and strategic planning.

Biegel, who participated in a session on Next-Generation Stress Testing at the 20th GARP Risk Convention, has been on both sides of the process. Before joining HSBC in 2016, he was with the Bank of England, where he led the design and implementation of its first concurrent stress testing exercise in 2014.

Interviewed during the convention, Biegel says he sees “great value in running the entire banking sector through severe economic stress” to ensure that capital levels are adequate to withstand that stress. The sector is “arguably pretty well capitalized,” more likely to “serve as a shock absorber rather than a shock magnifier as it did in the last crisis.”

Growing Nonbank Activity

Risks, however, migrate, and now “it's the shadow banking sector, the financial system outside of banks, to keep an eye on,” Biegel adds.

He says that while regulators' macroprudential frameworks “have been very helpful,” stress testing can play a role in assessing “some of the impacts that could transmit through the financial sector from deterioration of credit” in shadow banking. A specific concern is the growth of private debt, or private equity and hedge fund firms' lending to companies traditionally served by banks, and its potential impact on financial stability.

The U.S. Treasury‐led Financial Stability Oversight Council called attention in its most recent annual report to growing nonbank market shares in such areas as corporate debt, including leveraged loans, and mortgage lending and servicing. The FSOC also pointed out that “nonbank financial companies designated by the Council” can be subject to stress testing under section 165(i) of the Dodd‐Frank Act.

Video production by DeLisa White

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