An outgrowth of Dodd-Frank, the Wall Street Reform and Consumer Protection Act, was that financial institutions with more than $250 billion in assets must analyze their business using hypothetical economic scenarios. This function is known as the Supervisory Stress Test. You can find the 2021 report here. How can this help better manage credit losses?
The concept is sound, and it forces bankers to consider business and credit risks under various conditions. Last year, even with COVID, banks passed the tests (with perhaps a little help from CECL). Moreover, the Federal Deposit Insurance Corporation (FDIC) notes that a “severely adverse scenario is not a forecast. Instead, it is a hypothetical scenario designed to assess the strength and resilience of financial institutions.
Each scenario includes 28 variables—gross domestic product, the unemployment rate, stock market prices, and interest rates—covering domestic and international economic activity.
The FDIC coordinated with the Board of Governors of the Federal Reserve System and the Office of the Comptroller of the Currency in developing and distributing these scenarios.
While bank accountants and financial professionals will spend the next few weeks working on their models, it is interesting to note the Federal Reserve’s stress scenarios for top banks. Admittedly, some metrics seem optimistic, so remember the Fed warns that the variables are not forecasts but intended to assess strength and resilience. But, for lay people, let’s take a look to get a sense of what credit managers should expect over the next two years.
Real GDP Growth
Few will forget the 31.2% drop in real GDP growth during 3Q2020, with a fourth-quarter bounceback as the world braced for COVID. The base input tempers during 2023 and 2024, with GDP growth at a quarterly high of 2.5%, ending at 2.0% in 4Q24. Under the severe scenario state, the projection dips to -1.8%.
Unemployment Rate: Critical Driver for Credit Losses
Life looks rosy with a steady estimate of 3.5% to 3.6% unemployment for the next eight quarters under the base scenario, though a rugged metric appears under the severe scenario. There it peaks at a whopping 10.0% come Q32023, ending in 2024 at 7.4%. Many credit managers use the unemployment rate as a critical driver for credit losses.
Consumer Price Index Inflation Rate
This one is a bit hard to grasp. With the 4Q2021 rate pegged at 8.2%, using 3.9% in 1Q22 seems slightly low and projecting down to 2.1% during 4Q2024 seems very optimistic under the base case. In the severe scenario, the CPI Inflation rate is a mere 1.6%. I hope so.
2024 will be a presidential election year, so perhaps my caution is a bit skeptical. I hope so.
Prime Rate
The severe scenario for 4Q2024 is only 3.1%, and the base case is 4.6%. So keep the metric under 6.5%, and most credit managers should be happy.
Stress tests are necessary; the numbers behind those forecasts are essential. Credit card growth models that feed into these input variables must handle credit loss rates, not just in 2022 but a few years ahead.
Overview by Brian Riley, Director, Credit Advisory Service at Mercator Advisory Group