STRESS-S-S-S-S-S-S-!

With everyone stressed about the elections, I will stick to this general theme and discuss my forthcoming article on stress testing, which is a method of bank regulation popularized by the Dodd-Frank Act in which the Federal Reserve sets adverse economic scenarios to examine whether big banks have enough capital to survive an economic crisis that stresses them to the limit.  Maybe the next stress scenario should be a crazy election?

There are currently no guiding models for stress testing, and this article fills the void by suggesting and deriving a Bayesian model, which is a kind of model that takes into account prior inputs.  In this context, the priors would be the previous Federal Reserve adverse scenarios because of industry belief that the Federal Reserve adapts its scenarios to stress certain portfolios, but remains consistent with its prior scenarios in terms of economic intuition.

The article concludes that, indeed, failure to consider these prior scenarios could underestimate a bank’s loan losses significantly in an adverse economic scenario – by as much as 25%.  This could be the difference between a successful stress test and a failed stress test.  A  failed stress test can be stress-inducing for bank clients, and, unlike elections, stress-testing is an annual event.

You can read the paper here.