The Future of Bank Stress Testing

By | February 21, 2018

As a presidential candidate, Donald Trump’s position on financial regulation was unclear. He promised to restore Glass-Steagall and at one point stated: “I know the people on Wall Street. We’re going to have the greatest negotiators of the world, but at the same time I’m not going to let Wall Street get away with murder. Wall Street has caused tremendous problems for us. We’re going to tax Wall Street.” But candidate Trump also vowed to repeal Dodd-Frank and said the legislation “makes it very hard for bankers to loan money for people to create jobs, for people with businesses to create jobs.”

Upon taking office, President Trump made his position perfectly clear when he called Dodd-Frank “a disaster” and promised to do a “big number” to the legislation. A roadmap started to take shape last February when the President released an Executive Order that laid out “Core Principles for Regulating the Unites States Financial System” and required the Secretary of the Treasury to report back within 120 days on whether governmental rules and policies promote or inhibit the order’s core principles. The Treasury Secretary complied last June when his department released a report assessing the depository system (banks and credit unions.)[1]

The report contains a number of recommendations that would alter nearly every aspect of post-crisis bank regulatory reform. However, the Treasury Department does not have the statutory authority to unilaterally implement these recommendations. Rather, their enactment requires a mix of legislative changes, new rulemakings by one or more bank regulatory agencies, or discretionary changes to agency enforcement of existing rules or standards.

This post is the first in a series that will group the recommendations in the Treasury report by topic and assess how close these recommendations are to becoming a reality. I begin by looking at recommendations pertaining to stress testing; both the Dodd-Frank Act Stress Test (DFAST) and the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR). To understand how stress testing may change going forward, I rely on the following sources:

  • a speech delivered in September of 2016 by former Federal Reserve Governor Daniel Tarullo that proposed a number of changes to the CCAR process;
  • three proposals pertaining to CCAR transparency released by the Federal Reserve for notice and comment in December of 2017;
  • the “Economic Growth, Regulatory Relief and Consumer Protection Act” (Senate Banking bill) which passed out of the Senate Banking Committee in December;
  • and recent comments by the Federal Reserve Board’s Vice Chair for Supervision, Randy Quarrels, that highlight his initial observations on how post-crisis regulation can be improved.

For each recommendation listed in the Treasury report – as summarized in Appendix B of the report – I provide a short status update based upon the above sources. I then provide additional details on each of these sources before concluding by summarizing the various regulatory currents and where they may lead.

TREASURY RECOMMENDATIONS

DFAST Threshold: The threshold for participation for company-run DFAST should be raised to $50 billion in total assets (from the current threshold of more than $10 billion). The banking regulators should be granted authority to further calibrate this threshold on an upward basis by reference to factors related to the degree of risks and complexity of the institution.

Status: The Senate Banking bill would exempt institutions with less than $250 billion in total consolidated assets from the annual Dodd-Frank Act Stress Test requirement.

DFAST Process: The mid-year DFAST cycle should be eliminated, and the number of supervisory scenarios should be reduced from three to two—the baseline and severely adverse scenario. Further, as a company-led process, leeway should be granted for banks to determine the appropriate number of models that are sufficient to develop appropriate output results, aligned with the scale and complexity of the banking organization and nature of its asset mix.

Status: The Senate Banking bill would permit banks with over $250 billion in assets to be subject to DFAST on a “periodic” basis, without clarifying what periodic means. The bill would not amend the number of supervisory scenarios. There are currently no proposals that would grant leeway to banks on determining the appropriate number of models.

CCAR: The Federal Reserve should (i) reassess assumptions in the CCAR process that create unrealistically conservative results, such as the assumption that firms continue to make capital distributions and grow their balance sheets and risk-weighted asset exposure in severely adverse scenarios; (ii) improve its modeling practices by better recognizing firms’ unique risk profiles; and (iii) consider changing the CCAR process to a two-year cycle (with more frequent reviews permitted to allow revisions to capital plans in the case of extraordinary events).

Status: In his speech, Governor Tarullo announced that the Fed was considering changing the CCAR assumption that a firm grow its balance sheet throughout the nine-quarter stress horizon and instead assume that a firm’s balance sheet and risk-weighted assets will remain constant and that a firm will maintain its dividends for one year while reducing its share repurchases. The CCAR exercise has yet to incorporate these assumptions, but the Fed’s proposed stress testing policy statement makes explicit the assumption that a firm’s balance sheet will be fixed or growing in the supervisory stress test. The Fed is also proposing additional clarity on how supervisory models are developed. The Senate Banking bill will keep CCAR as an annual exercise for banks exceeding $250 billion in assets while making the test “periodic” for banks in the $100 to $250 billion asset range.

Improving CCAR transparency: The Federal Reserve should subject its stress-testing and capital planning review frameworks to public notice and comment, including with respect to its models, economic scenarios, and other material parameters and methodologies.

Status: In December the Federal Reserve released three proposals for public comment that would increase the transparency of its stress testing program. These proposals touch on the Fed’s model development and disclosures as well as their scenario design framework.

CCAR qualitative assessment: The qualitative CCAR element should no longer be the sole basis for the Federal Reserve’s objection to capital plans for all banks subject to CCAR. The qualitative assessment should be adjusted to the horizontal capital review for all banking organizations (as the Federal Reserve has already implemented for non-complex banks with less than $250 billion in assets).

Status: In his farewell address, Governor Tarullo mentioned the possibility of one day phasing out the qualitative objection. However, there are currently no proposals to eliminate the qualitative component as a basis for the Federal Reserve’s objection to bank capital plans.

Other CCAR transparency modifications: The CCAR process could also be modified to provide management with greater control of capital distribution planning by providing firms an accurate understanding of the capital buffers they would have after considering the projected results of the Federal Reserve’s supervisory models under the severely adverse scenario. This additional certainty about the size of a firm’s capital cushion could be achieved through (i) changing the sequence of the CCAR process; or (ii) integrating the risk-based capital and CCAR stress testing regimes, without increasing post-stress capital requirements.

Status: Governor Tarullo introduced the concept of a stressed capital buffer to better align CCAR with risk-based capital requirements but the concept has yet to be incorporated into the stress test. There are no proposals to change the sequence of the CCAR process other than the Federal Reserve slightly tweaking the procedure for 2018 by providing firms with an opportunity to increase their planned common stock issuances in the period between when the Fed completes the supervisory stress test but before the disclosure of the final CCAR results. Previously, firms could only reduce planned capital distributions during this window.

 SUMMARY OF SOURCES

Governor Tarullo’s Speech

Following the 2015 CCAR cycle, which marked five years of post-crisis stress testing, the Federal Reserve conducted a comprehensive review of the stress testing program. In September of 2016, former Federal Reserve Governor Daniel Tarullo announced the results of the review and proposed a series of changes to CCAR. The most significant proposal was the introduction of a new stressed capital buffer (SCB) which would replace the current 2.5 percent capital conservation buffer as a component in each firm’s point-in-time capital requirements. The stressed capital buffer would be set equal to the maximum decline in a firm’s common equity tier 1 capital ratio under the severely adverse scenario of the supervisory stress test before the inclusion of the firm’s planned capital distributions. This change would only apply to the eight global systemically important banks (G-SIBS) and these banks would see an increase in their capital requirements as a result.

Tarullo also proposed changing the current CCAR assumption that a firm’s balance sheet increases during the severely adverse scenario and that all of a firm’s planned dividends and share repurchases would proceed during CCAR’s two-year planning horizon. Instead, the Fed would assume that a firm’s balance sheet and risk-weighted assets will remain constant and that each firm will maintain its dividends for one year while reducing its share repurchases.

Tarullo also announced that CCAR’s qualitative component would no longer apply to banks with less than $250 billion in assets and that do not have significant international or nonbank activity. The Fed finalized this rule change last June.

Finally, Tarullo indicated that the Fed was willing to provide more transparency into how the stress scenarios and supervisory model parameters are developed. However, he was adamant that the Fed will not publish the full computer code utilized in the supervisory models to project revenues and losses.

Three Federal Reserve proposals to increase CCAR transparency

While most of Tarullo’s proposed changes have yet to make their way into the CCAR exercise, the Fed put forward a package of proposals for public comment this past December that would largely incorporate Tarullo’s recommendations to improve CCAR’s transparency. The comment window closed last month and the proposals look set to be finalized shortly with minimal changes.

  1. Policy Statement on the Scenario Design Framework for Stress Testing

In their proposal to amend the “Policy Statement on the Scenario Design Framework for Stress Testing”, the Fed seeks to change how the unemployment rate and house prices are determined under the severely adverse scenario. The Fed is proposing that the unemployment rate may increase by less than 4 percentage points (which has been the average increase in previous years scenarios) when the unemployment rate at the start of the scenarios is elevated but the labor market is strengthening and higher-than-usual credit losses stemming from previously elevated unemployment rates were either already realized, or are in the process of being realized. This change would result in smaller changes to the unemployment rate in the severely adverse scenario during periods when the economy is recovering.[2]

The proposal would also provide more clarity on the path of house prices over the planning horizon by linking house prices to the ratio of the nominal house price index to nominal per capita disposable income. This change would have little impact on the overall stringency of the stress test.

Finally, the proposal states that the Fed may include variables in all three scenarios that would reflect the cost of short term wholesale funding, which if implemented, would likely increase the stringency of the stress test.

  1. Stress Testing Policy Statement

In their proposed policy statement on the approach to supervisory stress testing, the Fed outlines key principles and policies governing their approach to the development, implementation, and validation of models used in the supervisory tress test. The prosed policy statement would have no impact on the overall stringency of the test, but it would provide more clarity on how the Fed develops and utilizes their supervisory models.

  1. Enhanced Disclosure of the Models Used in the Federal Reserve’s Supervisory Stress Test

The most significant changes to the CCAR exercise would result from the Fed’s proposal to enhance disclosure of the models used in the supervisory stress test. The enhanced disclosures have three components: (1) enhanced descriptions of supervisory models, including key variables; (2) modeled loss rates on loans grouped by important risk characteristics and summary statistics associated with the loans in each group; and, (3) portfolios of hypothetical loans and the estimated loss rates associated with the loans in each portfolio.

The enhanced descriptions would provide more detailed information about the structure of the models, such as equations that are utilized to determine probability of default (PD), loss given default (LGD), and exposure at default (EAD). They would also include a table that contains a list of the key loan characteristics and macroeconomic variables that influence the results of a given model.

The enhanced disclosures would also include estimated loss rates for groups of loans with distinct characteristics, which would allow the public to see how the supervisory model treats specific assets under stress and illustrate how changes in macroeconomic conditions influence modeled loss rates. In addition, the proposal indicates that the Fed may publish portfolios of hypothetical loans that outside parties could then use in their own models to estimate losses.

Most importantly for firms, in their proposal the Fed acknowledges that they could [emphasis added] disclose the loss rates estimated by the supervisory models for each portfolio of hypothetical loans. Such disclosure would allow firms to calibrate their models more closely to the Fed’s.

Senate Banking Bill

The “Economic Growth, Regulatory Relief and Consumer Protection Act” (Senate Banking bill) passed out of the Senate Banking Committee in December on a bipartisan basis and is awaiting debate in the full Senate. The bill appears set to pass the full Senate thanks in part to the twelve Democrats co-sponsoring the bill, although the bill has sharply split Senate Democrats. The bill is specifically tailored to provide regulatory relief to community and regional banks which makes it different from the House passed Financial CHOICE Act which essentially guts most of Dodd-Frank and stands zero chance of passing in the Senate – which is why it is excluded from our analysis.

Section 401 of the Senate Banking bill raises the threshold for applying enhanced prudential standards (the so called SIFI threshold) from $50 billion to $250 billion in assets. The Federal Reserve will still have the authority to apply enhanced prudential standards to bank holding companies (BHC’s) with total consolidated assets between $100 billion and $250 billion under certain conditions. The new SIFI threshold means BHC’s with consolidated assets between $100 – $250 billion will be subject to supervisory stress testing (CCAR) on a “periodic” basis, which seems to imply that for these institutions, CCAR will not be an annual exercise. CCAR will continue to be an annual exercise for banks with over $250 billion in consolidated assets, although the currently required three supervisory scenarios (baseline, adverse, and severely adverse) would be reduced to two (baseline and severely adverse).  BHC’s with total consolidated assets of less than $100 billion would no longer be subject to statutorily-mandated supervisory stress tests.

Institutions with less than $250 billion in total consolidated assets would be exempt from the annual Dodd-Frank Act Stress Test requirement (the company run stress test) while firms above this threshold would be permitted to run the test on a “periodic” basis, rather than semiannually. The bill does not change  the requirement that company-run stress tests include at least three scenarios (baseline, adverse, and severely adverse).

Quarles Speech

Randal Quarles became the Federal Reserve Board’s Vice Chairman for Supervision in October 2017. The Vice Chairman for Supervision position was created by Dodd-Frank but had gone unfilled under the Obama administration, although functionally the role was filled by Daniel Tarullo. Governor Quarles spent his initial months in office assessing the impact of post-crisis regulatory reforms and in a speech last month offered his initial thoughts on potential changes to post-crisis regulatory framework; changes which he will play an instrumental role in enacting.

Governor Quarles supports congressional efforts to tailor regulation to risk, whether by raising the current $50 billion SIFI threshold or by articulating a so-called factors-based threshold. When it comes to stress testing, Governor Quarles believes additional tailoring by asset size and risk factors is warranted, although he stopped short of offering specific recommendations. Finally, Governor Quarles supports the Federal Reserve’s efforts to improve stress testing transparency and believes the Fed can do even more in this regard.

Conclusion

The Treasury Department recognizes that stress testing is a critical supervisory tool designed to ensure that banks have sufficient capital to withstand a severe economic downturn. However, Treasury believes the current stress testing framework is too opaque and their report offers a number of recommendations for increasing transparency into how the stress scenarios and supervisory models are developed. The Federal Reserve appears set to incorporate several of these recommendations, although they do not go as far as Treasury would like. The Treasury Department also seeks to exempt non-systemically important banks from the most onerous stress testing requirements and the Senate Banking bill, if passed into law, would largely accomplish this.

Financial institutions hoping that the appointment of Mr. Quarles as Vice Chairman for Supervision would immediately usher in a reduced regulatory burden were surely disappointed earlier this month when the Federal Reserve released their scenarios for CCAR 2018 and the severely adverse scenario imagined a more severe economic downturn than last year’s scenario. That said, I expect Governor Quarles to play a major role in supervisory stress testing going forward, as he has already signaled a desire for greater transparency and risk-tailoring in the tests.

 

 

 

 

[1] The Treasury Department has subsequently released three additional reports that cover capital markets, the asset management and insurance industry, and orderly liquidation authority. A fourth report on the non-bank financial sector is forthcoming.

[2] The current approach assumes that the unemployment rate would increase by the greater of a 3 to 5 percentage point increase from the unemployment rate at the beginning of the stress test planning horizon or would rise to 10%.

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