Following the financial crisis of 2007–2009, the Fed introduced its annual stress tests, which determine the necessary capital for banks to maintain financial health and the amount they can allocate to shareholders via share buybacks and dividends. For the first time, the 2024 test will incorporate the default scenario and additional exploratory analysis. The latter consists of four elements, two of which are exploratory market shocks of the banking system.
The two market shocks aim to assess lenders’ ability to withstand a broader spectrum of risks beyond those traditionally covered in the tests. Both require banks to assess losses from the default of their five biggest hedge fund counterparties. These inclusions highlight previously overlooked vulnerabilities stemming from exposures to hedge funds and could play a key role in averting a recurrence of bank losses incurred with the downfall of Archegos Capital Management in 2021.
The key distinction between the two scenarios lies in their scope: one concentrates on shocks localised within US markets, whereas the other assumes global disruptions. The Fed wants to assess the potential consequences by grasping a measure of the magnitude of losses across different asset classes in these distinct scenarios. Although both scenarios predict an expansion of credit spreads and a downturn in stock values, variations emerge in the reactions of foreign exchange rates, interest rates and commodities between the two scenarios.
This comprehensive Fed examination demonstrates the efforts undertaken by the Fed to thoroughly assess the resilience of banks against the effects of wrong-way risk (WWR) and jumps-at-default. Both factors are key components in the calculation of XVA (valuation adjustments) within the banking sector. Assessing and incorporating WWR and jumps-at-default into XVA calculations is important given they directly influence a bank’s exposure to counterparties during adverse conditions.
Contents
- Market vulnerabilities
- WWR and jumps-at-default: effects on CVA
- Overcoming XVA complexity
