Severe but Plausible — or Not?

30 Pages Posted: 12 Jan 2021 Last revised: 10 Mar 2021

See all articles by Stefan Gavell

Stefan Gavell

Program on International Financial Systems

Mark Kritzman

Windham Capital Management

Cel Kulasekaran

Windham Capital Management

Date Written: January 9, 2021

Abstract

In light of the COVID 19 crisis, the Federal Reserve has carried out stress tests to assess if major banks have sufficient capital to ensure their viability should a new and perhaps unprecedented crisis emerge. The Fed argues that the scenarios underpinning these stress tests are severe but plausible, yet they have not offered any evidence or framework for measuring the plausibility of their scenarios. If the scenarios are indeed plausible, it makes sense for banks to retain enough capital to withstand their occurrence. If, however, the scenarios are not reasonably plausible, banks will have deployed capital less productively than they otherwise could have, thereby impairing credit expansion and economic growth. The authors apply a measure of statistical unusualness, called the Mahalanobis distance, to assess the plausibility of the Fed’s stress scenarios. A first pass of their analysis, based on conventional statistical assumptions, reveals that the Fed’s scenarios are not even remotely plausible. However, the authors offer two modifications to their initial analysis that increase the scenarios’ plausibility. First, they show how the Fed can minimally modify their scenarios to render them marginally plausible in a Gaussian world. And second, they show how to evaluate the plausibility of the Fed’s scenarios by replacing the theoretical world of normality with a distribution that is empirically grounded.

Keywords: Alternative composite scenario, Comprehensive Capital Analysis and Review Program, COVID, Kurtosis, Mahalanobis distance, Severe but plausible, Skewness, Stress scenario, Stress test, Supervisory Capital Assessment Program

JEL Classification: C15, C18, C53, C58, C63, G17, G18, G21, G28, G31, G38

Suggested Citation

Gavell, Stefan and Kritzman, Mark and Kulasekaran, Cel, Severe but Plausible — or Not? (January 9, 2021). MIT Sloan Research Paper No. 6246-21, Available at SSRN: https://ssrn.com/abstract=3764123 or http://dx.doi.org/10.2139/ssrn.3764123

Stefan Gavell

Program on International Financial Systems ( email )

134 Mt Auburn St.
Cambridge, MA 02138
United States

Mark Kritzman (Contact Author)

Windham Capital Management ( email )

800 Boylston Street
30th Floor
Boston, MA 02199
United States
6174193900 (Phone)
6172365034 (Fax)

Cel Kulasekaran

Windham Capital Management

800 Boylston St
30th Floor
Boston, MA 02199
United States

HOME PAGE: http://www.windhamcapital.com

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