Consistent projections of balance sheet, risk-weighted assets, and income Model Symposium June 2013 Anna Kovner Federal Reserve Bank of NY The views expressed in this presentation are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System.
Consistency is hard to achieve Net income Changes to capital Changes to capital Change in asset mix Change in asset amount Change in asset quality Changes to RWA Provisions Capital Ratio 2
Even before projections need to vary with changes in macroeconomic conditions GDP Revenue Stock market Changes to Assets Provisions Unemploy ment Changes to RWA Changes to capital Housing 3
But consistency is critical If there is no consistency across models, the sum of the parts may be very different from what would occur in an adverse macroeconomic environment Do riskiest borrowers refinance? Are credit standards tightening? Does reducing risk of trading assets impair market making revenues? Is the expectation for interest income in the AFS/Securities portfolio similar to the expectation for interest income when the same assets are directly held? If model errors are correlated, the capital forecast will be biased 4
Federal Reserve Approach I Revenue Models Capital Calculations Model Oversight Group Asset Models Loss Models 5
Federal Reserve Approach II Model Oversight Group Single group reviews all models Encourages consistency Eg. Connects modeling of MBS exposures in securities book to on balance real estate exposures Modeling team Model Validation Unit Benchmark Models Content experts Encourages robust processes Alternate approaches to same question (eg. top down vs. bottom up, different specifications) can reveal inconsistencies Consistent, robust models of capital External Model Validation Council Insight from outside of Federal Reserve System on modeling approaches 6
Consistency across multiple dimensions Consistent data: 18 CCAR BHCs, next including the CAPR firms Pro forma for acquisitions where practical Consistent principles: Flight to quality is not consistent with the spirit of a stress test Revenues, expenses, assets, and risk weighted assets are linked higher revenues come at a cost; expense cuts may not materialize as planned; growth strategies may not be deployed as planned Unexpected negative events may occur 7
Adapting a budgeting methodology to forecasting a stress case can be difficult A B C D Balance Reference rate Spread Rate Interest income Borrower A 100 PRIME 50 B+C A X D Borrower B 125 900 A X D 100 Borrower C 200 LIBOR 50 B+C A X D Borrower D 500 PRIME 50 B+C A X D 800 Borrower E 300 60 A X D Borrower F 100 PRIME 50 B+C A X D Borrower G 20 EURIBOR 75 B+C A X D Borrower H 30 PRIME 50 B+C A X D Borrower I 100 800 A X D Total $1,475 75 175 8
Balances / Revenues / Provisions Severely adverse scenario: Increase in price of risk (BBB spreads), Decrease in LT treasury rates, ST rates remain at lower bound What might happen to loans? Interest income: Constant / lower interest income from OLD floating rate loans Assuming constant portfolio risk (including new originations and existing borrower renegotiations) Higher interest income Assuming risk decreases Higher or lower interest income Loan balances: Are same borrowers more or less risky? (given adverse macro environment) How are maturing and defaulting loans replaced? (if at all) How do new originations compare to the existing portfolio? While next slides show what happened historically, just because we see it 2007-8, doesn t mean it is in the spirit of a stress test 9
Balances / Revenues / Provisions In aggregate, when price of risk increases, loan balances stop growing and change in price of risk of loan portfolio dominates de-risking in the loan portfolio (coefficient on BBB spread is positive for interest income) Percent 10 9 8 7 6 5 4 3 2 1 0 5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 Dollars (Trillions) Interest Income on Loans / Total Loans (Annualized %) BBB Bond Yield - LT Treasury (%) LT Treasury (%) ST Treasury (%) Total Loans ($T) Source: Pro forma adjusted Y-9C data for sum of 18 CCAR firms. Includes firms only as they become Y-9C filers. 10
Compensation Compensation to assets has been trending down, but is not nearly as variable as the stock market 25 9.8 20 9.6 Percent 15 10 5 0 9.4 9.2 9 Log Value -5 8.8-10 8.6 Growth rate of Assets (%) Compensation/Assets (Annualized %) Log Dow Log Real GDP Source: Pro forma adjusted Y-9C data for sum of 18 CCAR firms. Includes firms only as they become Y-9C filers. 11
Deposits Deposit rates vary negatively with balances even after controlling for the fall in ST rates and even in crisis period 6 4.5 Percent 5 4 3 2 1 0 4 3.5 3 2.5 2 1.5 1 0.5 0 Dollars (Trillions) Interest expense on deposits/total Interest Bearing deposits (Annualized %) Service charges on deposits / Total domestic deposits (Annualized %) ST Treasury (%) Total Interest Bearing Deposits ($T) 12
Models vs. Expert Judgment Hard to evaluate if expert judgment is consistent across models (even if the same expert is doing everything) But, unvalidated models may be no better than expert judgment Would we rather be right or consistently, replicably wrong? BUT Experts can be wrong and have been Understand how and when different methods produce different answers 13
Challenges and trade-offs Consistency requires additional reviews of all models Pros Deeper understanding of implicit and explicit assumptions Challenges and testing of assumptions across models Cons Benefits of expert judgment likely diminished Hard to translate some implicit assumptions Time and resource intensive 14
A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. Ralph Waldo Emerson 15