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Scenario-driven Futures, 11 Feb 2016

All decision making in life is based upon scenarios, some more important than others, and some more controversial than others. Within the banking industry, the Federal Reserve’s scenarios for capital adequacy assessment (CCAR) are probably the most anticipated of the year.

The latest CCAR scenarios were released Jan 28, 2016, initiating the scramble to update all of the corresponding forecast models. This year’s scenarios are largely a continuation of the previous year’s, but with a few surprises included.

The following graph shows the current and previous severely adverse scenarios for Real GDP. The new scenario is supposed to represent a global downturn. As such, the recession appears to be a bit deeper than the previous version, but the overall pattern of recession is almost an exact copy.

For loan loss models, unemployment is always one of the primary drivers. In comparing these scenarios, we see that the unemployment rate reaches the same level with roughly the same pattern in both cases. The primary exception is that unemployment starts from a better point in Q4 2015 than in Q4 2014. Therefore, models dependent upon the change in unemployment will view these scenarios as more severe, a 4 point change versus a 5 point change.

For house prices, both scenarios capture a 25% deterioration in house prices. Since the absolute level of house prices is rarely used in modeling, the scenarios should appear to be equivalent.

The new interest rate scenarios are where most of the discussion is occurring. Whereas the previous scenario showed a slight increase of the 3-month Treasury rate to 0.1%, the new scenario proposes a drop in the rate to negative values. Although at first this seemed like only a hypothetical possibility, in the last month we have seen the Bank of Japan make just such a move to negative rates.

The logic behind this kind of scenario can be two-fold. The BoJ apparently took this action to push banks to lend more to spur economic growth. For those banks holding significant amounts of government bonds, negative rates are like a penalty fee. As one would expect, banks are unable to pass negative rates on to deposit customers, so this becomes a cost of not lending. Such a scenario could be plausible in the US where rates are also near zero already.

Secondly, negative rates could be a stress test of the model structures. Do deposit models implicitly assume that customers would pay to deposit their money in the bank? Might some of the model complex models give unintuitive answers with negative rates. Certainly some lenders are discovering that right now.

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