When results of the first official, company-wide stress tests performed by top-tier US banking groups were published by the Federal Reserve in May of 2009, markets, banks and regulators all breathed a sigh of relief. Though half of the 19 banks involved demonstrated capital shortfalls, the results allayed the markets’ fears about their long-term viability and greatly facilitated the banks’ subsequent funding and capital-raising activities. In the five years since this first public exercise, considerable advances have been made in US banks’ stress testing practices, particularly in three areas:
- US regulators were given unprecedented powers and responsibilities to set prudential standards under the Dodd-Frank Wall Street Reform and Consumer Protection Act (DFA);
- Stress testing has evolved into an ongoing exercise for the top-tier banks and a vital component of their annual capital plans, subject to stringent and highly-detailed examination by the Federal Reserve;
- Mid-sized ($10-50 billion) US banks are now having to incorporate stress testing into their own capital planning.
From the 2013 CCAR exercise to the next one…
The Federal Reserve’s annual review of top-tier banking groups’ capital plans, known as
- Four of the eighteen banking groups failed their exams and had to re-do them;
- An unspecified number received “Matter Requiring Attention” (MRA) or, even worse, “Matter Requiring Immediate Attention” (MRIA) letters relating to specific elements of their capital planning processes;
- And The Federal Reserve published a lengthy
report in August 2013 detailing lagging practices which needed to be corrected in each of its seven examination areas. Flaws in data integrity, aggregation, systems, reports, MIS and modeling were recurring themes in many sections of the report. Three of the Federal Reserve’s seven examination areas were particularly noteworthy for chronic weaknesses in the banks’ data and systems.[3]
1. Integrity of Reported Results
The Fed noted widespread use of antiquated, siloed and incompatible systems, requiring substantial human intervention to reconcile data. These systems were incapable of running ad hoc analysis without employing substantial resources. Furthermore, in many instances, banks’ models lacked proper documentation, change controls and independent model review and validation.
2. Estimation Methodologies
Some banks used models with low predictive power due to data limitations. Worse still, they also failed to compensate for the data limitations in their model results. Other banks with data limitations were unable to segment their portfolios adequately, thereby failing to capture significant geographic, industry or product concentrations. Another lagging practice was to model
3. Impact assessment on capital adequacy
Aggregating results was particularly challenging for banks with antiquated, siloed and incompatible systems. The Fed noted far too frequent uses of standalone tools or spreadsheets in the banks’ aggregation processes, together with limited or no reconciliation procedures to ensure integrity, completeness and accuracy of the consolidated post-stress capital metrics.
Whether or not these remedial pointers were addressed by all the top-tier US banks in their 2014 CCAR submissions remains to be seen. For the first time in 2014, the original group of eighteen were joined by the next twelve largest US banks in submitting their capital plans to the Federal Reserve on January 7. The impact of relying on lagging practices will be all too evident to the examiners, given the extent and complexity of the 2014 CCAR reporting requirements: three supervisory scenarios (baseline, adverse and severely adverse), each with 28 macro-economic variables; two bank-chosen scenarios (baseline and stress) custom-designed to highlight risks in the bank’s specific business model, all estimated over nine quarters; in addition, banks with large capital market trading operations were required to estimate losses from a global market shock and banks with global trading and/or custody operations were required to estimate losses from a major counterparty default.
Inviting paradigm-shifting solutions
In the past, US banks typically adopted an incremental approach to upgrading their systems and data capabilities to meet new or enhanced reporting requirements. The Federal Reserve’s August 2013 report clearly identified the limitations and weaknesses imposed by this approach. This was only one half of the story, however. Behind the scenes, at banks relying on legacy and patchwork systems, the daily diet of many professionals engaged in this massive, company-wide, once-a-year exercise was one of stress, distraction, overtime, delays, bottle-necks and band-aid solutions.
Two areas in the CCAR process stand out as inviting paradigm-shifting solutions. The first is for banks to implement a Project Management Office (PMO), in order to synchronize the multiple work-streams involved in CCAR preparation. This was a best practice highlighted in the Federal Reserve’s August 2013 report. For banks with a rigid organizational structure, this approach is understandably hard to implement. Conversely, in order to deliver a high-quality and timely CCAR package, these are the banks most likely to need it.
The second is to take a technological leap forward and adopt a factory-scale approach to reporting, analytics and controls. Global technology partners, such as HCL, specialize in organizing and aggregating granular data from multiple systems with disparate hierarchies and nodes, layering on analytics to produce the required derived data, and configuring the results to deliver a wide range of regulatory and management reports. Such an approach offers massive efficiency gains in speed, precision, traceability and reconciliation compared to relying on a patchwork of legacy systems. Equally important is the secondary benefit of giving the bank’s business and risk experts greater time and means to fine-tune their estimates, in order to meet or exceed the Federal Reserve’s current and future standards.
Meeting either the Federal Reserve’s or the markets’ expectations
For the twelve newcomer banks, satisfying the Federal Reserve’s 2014 CCAR technical and procedural standards for the first time will have been especially arduous, unless they elected to meet the challenge by adopting radical approaches such as those described above. At this point in the evolution of US banks’ capital planning processes, the question which each one should be asking is : can we afford to entrust our performance in a program which defines our dividend policy, share price and management reputation, and where a passing grade is insufficient to meet either the Federal Reserve’s or the markets’ expectations, to a siloed organization structure and a patchwork of legacy systems, when more flexible, reliable and timely alternatives are available?
