US financial watchdog flags up flaws in stress tests

Financial Times:

Bank stress tests are failing to take account of the potential systemic risks of large counterparties failing, the US government’s financial stability watchdog has warned.

The Office of Financial Research, set up after the 2008 financial crisis as part of the Dodd-Frank Act, conducted analysis of banks’ potential losses from credit derivatives exposures under regulatory stress scenarios.

Credit default swaps, which track the likelihood of default of a company or sovereign entity, were at the core of the financial crisis, optimised by the collapse of AIG. The insurance company received an $85bn bailout by the Federal Reserve Bank of New York after it had sold sizeable CDS protection that began experiencing losses.

The comprehensive capital analysis and review (CCAR) was brought in post-crisis to identify the source of capital losses at the largest US bank holding companies. It includes a scenario to assess a bank’s resilience to the failure of its largest trading counterparty.

The OFR analysis found that by focusing on a specific bank’s losses, CCAR ignores the potentially larger, indirect impact of a counterparty default on the bank’s other counterparties. It found that these indirect effects could be as much as nine times larger than the direct impact on a bank holding company.

Chilling, but it does explain how so many banks passed the stress tests.