Steve Bartlett and Etienne Diboti-Lobe
The Federal Reserve Board continues to evolve its approach to stress testing—proposing changes as recently as September for large banks, following an extensive review of its five-year-old program. While the Fed intends to increase requirements for the eight largest “global systematically important banks” (GSIBs), it would ease obligations for some in the next tier of banks ($50 billion to $250 billion in assets). Left largely unchanged under the proposed revisions would be provisions for mid-size banks (with $10 billion to $50 billion in assets).
The two stress tests that apply to banks and bank holding companies with more than $10 billion in assets are the Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Test (DFAST). Large covered institutions are subject to both CCAR and DFAST; mid-size covered institutions are subject only to DFAST.
Both tests replace the question “what” with “what if?” by specifying hypothetical macroeconomic and financial market scenarios to test financial institutions’ resilience. “What if 20 million workers are out of work?” “What if interest rates spike to record levels?”
In this article, we highlight some of the key points to know about stress testing.
What are the different expectations for mid-size and large banks?
At first glance, the CCAR and DFAST might look very similar, which can raise questions. The Fed’s response is that the two tests are complementary and that “both efforts are distinct testing exercises that rely on similar processes, data, supervisory exercises, and requirements.” The agency says it coordinates the processes to reduce duplicative requirements and minimize regulatory burden.
Larger banks face a higher level of scrutiny under the testing program than their mid-size peers. “For example, the expectations for data sources, data segmentation, sophistication of estimation practices approaches, reporting, and public disclosures are elevated for larger and more complex organizations than for $10-50 billion companies,” according to the FRB.
What is the guidance for conducting stress testing?
Every year the federal banking regulators provide financial institutions with scenarios required for covered institutions to use for stress testing, unless they are otherwise exempted for approved reasons. The three scenarios are: baseline, adverse, and severely adverse. Some of the forecasted macroeconomic conditions include drops in gross domestic product (GDP), unemployment spikes, and stock or housing market crashes, and their impact on capital, consolidated earnings, and losses.
In 2012, the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) jointly disclosed guidance on expectations for the dynamic stress testing framework, including the following attributes:
Strong governance and effective internal controls;
Activities and exercises that are tailored to and sufficiently capture the banking organization's exposures, activities, and risks;
Employment of multiple conceptually sound stress testing activities and approaches;
A framework that is forward-looking and flexible; and
Results that are clear, actionable, well supported, and useful to decision-makers.
More at: Federal Reserve Bank Supervision and Regulation Letters
What are the consequences of failing the DFAST for mid-size banks?
Unlike at large banks, mid-size banks’ stress test results are not graded by the Fed and don’t result in a “pass” or “fail.” While it is required for mid-size banks to self-disclose their results, these do not amount to a consolidated report by the Fed. With that said, some of the actions that the Fed can issue for poor stress test data, analytics, and processes apply to mid-size banks as well as their larger peers. Regardless, regulators will be interested in a mid-size bank’s DFAST processes and results when evaluating potential mergers and acquisitions, dividend payments, and redemptions of regulatory capital instruments. Though the evaluation of results is not directly enforced, the board of directors and senior management must help integrate the DFAST results in capital planning, assessment of capital adequacy, and risk management practices.
If we fail the stress test, what can we do?
For large banks with assets greater than $50 billion, the Fed will be evaluating reported stress tests with greater scrutiny than their smaller peers. The tests will be graded and results will be reported publicly on the Fed’s website. Failure can be attributed to poor processes, governance vulnerabilities, and infrastructure reporting deficiencies.
Failure can result in a ban on any capital distributions by the bank, without prior regulatory permission. In the case of non-US banks with a US subsidiary, failing the stress test prevents those US entities from distributing capital to their parent companies.
In the past two years, a few of the largest and well-known institutions have failed due to “qualitative” or “quantitative” concerns. The Fed concluded in 2015 that two large banks needed to remediate their failures by correcting and resubmitting their capital plans. If the issues persist, the Fed could administer a cease-and-desist order, which compels an organization to make specific changes or pay a fine. In 2014, a large bank’s capital plan failed to pass the Fed’s approval. A year later, it passed, which allowed it to increase
its dividends for the first time since 2008.
The Side Benefits of Stress Testing
Required stress testing should not be viewed only as an obligation, but as a cultural tool that can also help bolster risk management and governance processes at your financial institution. If conducted according to guidelines and expectations, stress testing and the Fed’s public disclosure of successful results can serve financial institutions as an opportunity to boost credibility, transparency, and the public’s confidence in the financial system.
View as PDF
Treliant Risk Advisors, Compliance, Risk Management, and Strategic Advisors to the Financial Services Industry, brings to you New Coordinates, a quarterly newsletter offering insights and information regarding pertinent issues affecting the financial services industry. This article appeared in its entirety in the 2016 Outlook issue. To subscribe to our quarterly newsletter, please Contact Us.