Utah Turns to Budget ‘Stress Tests’ to Help Prepare for Future Downturns

By using the same “stress tests” the Federal Reserve applies to large banking firms, the state of Utah is looking to provide additional insight into how well its finances would withstand the shrunken revenues, and fattened costs, that could accompany the next recession.

The state is among the first—if not the first—to conduct such tests on both the revenue and expenditure sides of its budget. Doing so has offered a window into not only how tax revenue could drop in a downturn, but also how costs tied to areas such as higher education and Medicaid might go up. While not seen as a silver bullet in terms of predicting how the state’s finances will fare in bad times, the stress testing is viewed as an added tool lawmakers, and others, can use to craft the state’s budget and dial in the level of its reserve funds.

The Governor’s Office of Management and Budget began work on the stress testing last spring, which continued into the fall, and also involved the Office of the Legislative Fiscal Analyst.

“It’s like a process drill,” Kristen Cox, director of the Office of Management and Budget, said during a phone interview in early January. “If there’s an earthquake, what would you do?”

‘A Strong Practice’

Ratings agencies have viewed the tests as a positive step. Analysts at Standard & Poor’s said last week that the tests illustrate a commitment to forward-looking fiscal planning. Utah already enjoys sterling credit ratings and a reputation for strong financial management.

“Modeling out what a recession would look like, and how it would affect their finances, and using that as a basis for funding their reserves, is a strong practice,” Gabriel Petek, a credit analyst at Standard & Poor’s, said by phone.

In late December, Standard & Poor’s affirmed its AAA long-term rating on Utah’s $2.5 billion of outstanding general obligation bonds, specifically citing, among other things, the state’s “proactive budget adjustments to maintain adequate ‘rainy day’ reserves.”

Rainy day fund balances in the state now exceed levels they were at prior to the Great Recession, according to Gov. Gary Herbert’s latest budget proposal, which was released in December. The proposal says the state now has nearly $528 million in its four main rainy day funds, which are designated for general fund spending, education, disaster relief and Medicaid.

Following the last recession, which struck in late 2007, Utah’s rainy day funds and other reserves proved to be important.

To help balance the state budget, the general and education funds were together drawn down to $209.3 million in 2010, from $418.5 million in 2009, according to a 2011 budget summary issued by the governor’s office.

How the Testing Worked

Central to the Federal Reserve stress tests are a pair of hypothetical scenarios meant to simulate the bad economic conditions that would play out during a recession. The two scenarios vary in terms of severity, with the milder one described as “adverse,” and the more extreme one referred to as “severely adverse.”

Annual stress testing of large banking firms is required under the Dodd-Frank law, which President Obama signed in 2010, in the aftermath of the 2008 financial crisis.

Scenarios the Federal Reserve released for last year’s stress tests include hypothetical “trajectories” for 28 variables, which change over the course of a timespan that ranges from 2001 to 2017. Among the variables are categories such as gross domestic product growth, disposable income growth, interest rates and unemployment figures.

Here’s how the Federal Reserve describes the behavior of a few of the variables included in last year’s severely adverse scenario: the unemployment rate increases by 4 percentage points from its level in the third quarter of 2014, and peaks at 10 percent in mid-2016; GDP drops; the price of equities, such as stocks, falls by about 60 percent from the third quarter of 2014 through the fourth quarter of 2015.

So how did Utah use these scenarios to stress test its budget?

The state, like others, forecasts revenues and expenditures. Described in basic terms, the stress testing involved plugging variables from the Federal Reserve scenarios into the state’s forecasting models to see what would happen. The results offered some indication of how much Utah would need in reserve funds to cover the revenue declines, and added costs, that occurred in the two hypothetical recession scenarios.

“It kind of helped us understand that, right now, if there were a typical recession, we have sufficient rainy day funds,” Cox said. “It was very helpful in shedding light on that.”

Jonathan C. Ball, director of the legislative fiscal office, offered a similar assessment. “At least for a typical recession,” he said, “absolutely, I think we're in good shape.”

The stress testing came on top of Utah’s ongoing efforts to look at revenue volatility—a term that refers to how prone a given source of revenue is to swinging up or down. Analyzing past trends, to assess how streams of state income might perform in the future, is another budget-planning technique Utah has used in recent years.

Ball emphasized that examining revenue volatility and trends are both important for financial planning. But the stress testing, he said, improves on this work in two key ways.

One way is that it zooms out, and looks at the broader economic picture portrayed in the Federal Reserve scenarios, rather than focusing more narrowly on state-level revenue volatility and trends. The second improvement, he said, is that the testing also takes expenditures, and not just revenues, into consideration.

“There’s lots of literature out there about revenue, about the volatility of revenue, and how to measure and manage volatility of revenue,” Ball said. “But that’s not the whole picture. Adding that expenditure side is really quite helpful.”

He added: “You can imagine, things like Medicaid, which is one of our biggest budget drivers, that was a huge impact.”

This is because when the economy tanks, Medicaid enrollment tends to swell. The program provides access to healthcare coverage for people with low incomes. Likewise, higher education costs usually rise during a recession, Ball said, because people out of work commonly head back to school.

Running the tests, he explained, drove home the point that during a recession “we have worse revenues, and we have more demand, so now what?”

It ‘Brings Reality To You’

Utah’s legislative session kicks off next Monday. In the weeks that follow, lawmakers will work to hammer out how they’d like the budget to look in fiscal year 2017, which begins on July 1.

The stress-testing results are expected to inform that work.

“I do think it will be useful,” said Rep. Brad R. Wilson, a Republican who hails from Kaysville, a community north of Salt Lake City. 

“We’ve got a lot of different ways to get line of sight to how healthy the state is,” he continued. “Stress testing is another way.”

Wilson sits on the Executive Appropriations Committee, which includes lawmakers from both the House and Senate.

In the course of the budgeting process, eight appropriations subcommittees that focus on specific topics, like natural resources and social services, report back to the panel with recommendations about how to allocate the state’s funds.

Legislative fiscal staff, late last year, presented the Executive Appropriations Committee with information about the stress testing results. State Sen. Lyle W. Hillyard, a Republican who represents a district that includes the city of Logan is the committee's chairman.

“I think the stress test brings reality to you, so you don’t immediately ask: ‘How much new money do we have this year to spend?’ But more importantly: How are we going to spend it? What do we need to be concerned about?” Hillyard said during a phone interview last week.

He also said that after seeing the results of the stress testing, his feeling was the state was “in pretty good shape” overall. But “we’re not to where I want to be,” he added. “We certainly found that there were parts in the budget that need to be reinforced and looked at carefully.”

Cox, the Office of Management and Budget director, said that, for her, the results of the stress testing were not that surprising, and reaffirmed that the state has an ample amount of money set aside in rainy day funds, and other types of reserves.

"States are always wanting to put money away in rainy day funds," Cox said. "But the question is: How much?"

“Our concern has been setting aside money for the sake of saying, ‘we’re conservative, we’ve planned for a rainy day,” she added. “That has an opportunity cost. You set money aside and it’s not going to education, for example.”

‘We Want To Go Further With It’

Looking ahead, there are plans to build on the stress-testing process carried out last year.

Phil Dean, Utah's budget director and chief economist, said this might entail looking at some of the smaller segments of the state's budget.

“We said in this first year we are going to look at these really big rocks, and we certainly don’t want to get all the way in the weeds,” he said.

Ball, the legislative fiscal office director, said there have also been discussions about including additional scenarios in the tests, and looking at more market “what-ifs.” For instance: a rise in oil prices, a devaluation of China’s currency, or increased interest rates.

“We’re excited about this,” Ball said. “We want to go further with it.”