Prudential Stress Testing in Theory and Practice: Comments on 'Stressed Out: Macroprudential Principles for Stress Testing'

I am pleased to have this opportunity to be with you today to discuss stress testing. In the wake of the housing bust and subsequent financial turmoil, the regulation and supervision of financial institutions and markets has been the subject of intense scrutiny. The 2009 U.S. stress tests appeared to play a critical role in the resolution of the crisis, which has led to recommendations that such tests, with appropriate refinements, be made a routine component of the supervisory regime for large financial institutions. Indeed, as the authors note, the Dodd-Frank Act mandates annual stress tests for bank holding companies and nonbank financial firms supervised by the Federal Reserve. Analysis of the motivation for and design of supervisory stress tests is therefore well worthwhile. In this paper the authors draw a sharp distinction between microprudential and macroprudential approaches to regulation, and they use this distinction as the main lens through which they assess the current conduct of stress tests. They distinguish between the different theoretical motivations for microprudential and macroprudential regulation, and contrast what they view as distinct practices associated with the two approaches. They go on to sketch out a method of evaluating the overall strength of a banking system based on correlations between equity prices and CDS spreads. On the basis of their analysis, they argue that the stress tests conducted in the U.S. in 2009 and Europe in 2010 have brought about insufficient improvements in financial conditions. And they conclude with a set of recommendations for regulators as to how their stress tests should be improved.