By Pam Martens and Russ Martens: September 17, 2020 ~

Randal Quarles, Vice Chairman for Supervision, Federal Reserve

At the time the Fed released the results of its bank stress tests in June, it announced that because of the pandemic and unprecedented economic downturn, it would require additional stress testing of the biggest banks later this year. This afternoon, the Fed released those plans.

Among the various hypothetical scenarios that the banks will have to perform against, 13 of the banks with significant trading operations will have to consider what would happen if a major counterparty blew up. The banks that will have to submit outcomes under this scenario include: Bank of America, Bank of New York Mellon, Barclays US, Citigroup, Credit Suisse, Deutsche Bank USA, Goldman Sachs, HSBC, JPMorgan Chase, Morgan Stanley, State Street, UBS, and Wells Fargo. The Fed will release bank-specific results before the end of the year.

All 34 banks will face two hypothetical scenarios featuring severe economic downturns. Both hypothetical scenarios feature high unemployment continuing into 2021. (Read the full details of the scenarios in this Fed booklet.)

The counterparty default scenario works like this, according to the Fed:

“Firms with substantial trading or custodial operations will be required to incorporate a counterparty default scenario component into their supervisory severely adverse and alternative severe stress scenarios for the resubmission of capital plans in the fourth quarter of 2020. The counterparty default scenario component involves the instantaneous and unexpected default of the firm’s largest counterparty.

“In connection with the counterparty default scenario component, these firms will be required to estimate and report the potential losses and related effects on capital associated with the instantaneous and unexpected default of the counterparty that would generate the largest losses across their derivatives and securities financing activities, including securities lending and repurchase or reverse repurchase agreement activities. The counterparty default scenario component is an add-on to the macroeconomic conditions and financial market environments specified in the supervisory severely adverse and alternative severe scenarios.

“The largest counterparty of each firm will be determined by net stressed losses. Net stressed losses are estimated by applying the global market shock to revalue non-cash securities financing transactions (securities or collateral posted or received); and, for derivatives, the trade position and non-cash collateral exchanged. The as-of date for the counterparty default scenario component is June 30, 2020—the same date as for the global market shock.”

It’s notable that the Fed is going to be looking at the “largest counterparty of each firm” and what would happen if it blew up. Let’s hope the Fed has the good sense to look to see just how concentrated that counterparty risk is to other banks.

Back in the days when we actually had an Office of Financial Research (OFR) (before its funding and staff were gutted) we learned that the Fed was actually conducting its stress tests all wrong.

OFR researchers, Jill Cetina, Mark Paddrik, and Sriram Rajan, produced a study in 2016 showing that, in their opinion, the Fed’s stress test that measures counterparty risk on a bank by bank basis was ill-conceived. The problem, according to the researchers, is not what would happen if the largest counterparty to a specific bank failed but what would happen if that counterparty happened to be the counterparty to other systemically important Wall Street banks. (Think Lehman Brothers and AIG in 2008.)

The researchers wrote that the Fed’s stress test “looks exclusively at the direct loss concentration risk, and does not consider the ramifications of indirect losses that may come through a shared counterparty, who is systemically important.” By focusing on “bank-level solvency” instead of the system as a whole, the Fed may be ignoring the real problem of systemic risks in the system. The researchers explained:

“A BHC [bank holding company] may be able to manage the failure of its largest counterparty when other BHCs do not concurrently realize losses from the same counterparty’s failure. However, when a shared counterparty fails, banks may experience additional stress. The financial system is much more concentrated to (and firms’ risk management is less prepared for) the failure of the system’s largest counterparty. Thus, the impact of a material counterparty’s failure could affect the core banking system in a manner that CCAR [one of the Fed’s stress tests] may not fully capture.”

AIG and Lehman Brothers turned out to be not so much real counterparties to contain risk on Wall Street but a gamble by the big Wall Street banks on how much fleecing of the U.S. taxpayer Congress would allow to cover bad gambling debts on Wall Street. The answer turned out to be an open money spigot from the Fed.