Stressing the Fed Stress Tests Against COVID-19

Abstract

COVID-19 is a new type of shock that is likely to produce losses on loans and financial assets higher and more correlated than historical adverse macroeconomic shocks unless policy stabilization efforts are successful. Further, the sudden economic stop caused by the need for social distancing requires bridge financing to support existing contractual arrangements for employment, debt service, and a range of other obligations. Society has resources in the form of taxation of future income that it can move to the present to provide bridge financing and absorb losses from defaulting loans and ensure that existing forms of capital (physical, human and intangible) remain available for production after the COVID-19 virus wanes. For the US this is taking the form of transfers, direct loans and equity from the US Treasury (UST), and UST “capital” used to back the Federal Reserve’s various lending facilities under its 13(3) authority. The goal of this note is to provide a simple framework to analyze how much UST capital is needed to back the Fed Facilities to achieve the stabilization goal. Simply put, what should be the aggregate capacity (leverage) of the facilities, and how much capital will be available in tail outcomes where the private banking system faces losses greater than its substantial capital buffer? We will bootstrap recent Federal Reserve stress test results to illustrate some possible answers to these questions. This is the notion of how we are stressing the stress tests.

Keywords: capital adequacy, risk management, crisis

JEL Classification: G01, G21, G28, G32