Banks Need to Improve Their Approach to Stress Tests

Apr 17 2014, 2:50pm CDT | by

The Dodd-Frank Act (DFA) established the stress tests and Comprehensive Capital Analysis and Review (CCAR) to determine the stability of the banking system.  Since the stress and capital requirements tests were first implemented in 2009, we’ve observed that it has tended to help banks gain a better understanding of their overall risk profiles, better manage risks across lines of business and foster confidence, both among regulators and in the marketplace.

There is little doubt, nearly five years later, that most banks have improved their capital position and their stability along with their profitability.  The key question now is how banks position themselves and execute their business strategy under the new capital structures to drive competitive advantage, improve profitability through innovation and deliver value to the shareholder.

The Federal Reserve, which administers the CCAR process and stress tests, has provided guidelines for banks regarding the uses of excess capital.  The Fed has noted, for example, that dividend payouts are to be conservative and that planned dividend payout ratios above 30 percent of projected after-tax net income “will receive particularly close scrutiny,” as was reported by Forbes.com and others.

As a part of the latest round of CCAR submissions, the Fed expanded the submission universe, now mandating that mid-tier banks also submit stress test results.

For banks of all sizes, perhaps the greatest challenge resulting from CCAR and stress testing is the time and effort it requires for already overburdened leadership across risk and finance – as well as the IT support functions.  As the processes mature and the banks view CCAR as a strategic tool for decisions beyond compliance, they have continued to make investments, developing more robust operating frameworks, applying quantitative forecasting methodologies, updating infrastructure and technology with analytics and data aggregating tools, and fine-tuning execution capabilities.  Many banks are looking for better systems – and better data – to improve their stress testing and capital planning process.  Large banks, in particular, are implementing automation frameworks to support risk modeling and take some of the burden off of their risk and finance officers.

While many banks have invested in point solutions and software, opportunity remains for banks to establish robust frameworks that integrate data, modeling, analytics and reporting capabilities across all lines of business and all geographies.

Looking ahead, there are five elements that will help large and mid-size banks better prepare for the 2015 edition of stress testing and CCAR submission:

  • Strong Governance Framework. In order to maintain stability and consistency across the enterprise and the governance structure, banks will want to focus on regulatory mandates, process, models and technology.  Senior management needs to be involved in driving and implementing a strong end-to-end governance framework across the organization.  The Board of Directors and senior management should be involved early in the preparation process and confirm the final capital plan submission.
  • Risk and Controls Framework. A risk and controls framework helps ensure that the methodologies and business assumptions about the bank’s response to proposed stresses are challenged and validated by people who sit in the driver’s seat, to encourage a candid assessment of the bank’s real vulnerabilities.
  • Taking a proactive approach. Leading banks are increasingly conducting company-wide stress tests to assess institutional resilience in the face of adverse market conditions.  Using new methodologies including forecasting based on pre-provision net revenue (PPNR) models– essentially revenues and non-credit related expenses – these banks integrate stress testing across business areas, asset classes and risk types, including credit, market, liquidity, operational, franchise and regulatory risks.  Banks that adopt these processes are more likely to be well-prepared when presented with specific scenarios from the Federal Reserve Bank.
  • Integrating the flow of data. Banks have much more work to do when it comes to integrating the flow of data that moves in (and out of) various key functions including risk, finance, compliance and operations.  For many banks, this means centralizing resources at the enterprise level and promoting both top-down and bottom up flows of information. In addition to data flows, the banks need to continue their focus on data quality, granularity and frequency by industrializing data layers and establishing a common data framework between risk and finance. Data granularity is essential, as institutions revisit and develop quantitative based forecasted (PPNR) methodologies, as expected by the regulators.
  • Seeing stress testing as a process, not an event. Stress tests have been increasingly leveraged since 2009 and are being used on a growing number of banks; in short, they are most likely here to stay.  Banks would do well to look at stress testing more in terms of a quarterly physical, requiring monitoring and lifestyle changes, rather than as a final exam to be passed and then forgotten.  To take full advantage of CCAR and to drive efficiencies, the organizations should focus on developing an operating model that allows them to integrate the CCAR process into the existing capital planning, forecasting and Basel processes.

Regulatory authorities have found stress testing to be a useful tool to assess the strength of the U.S. financial system.  The banks can take advantage of CCAR and use the process as a strategic tool to develop strategy and manage their business along with their existing internal processes.  A systematic, integrated approach to stress testing allows banks to see where they are vulnerable and where pressure points might emerge in a given distress environment.  Stress testing provides a key diagnostic that can help banks determine whether their capital plans make sense or whether additional steps should be taken to strengthen reserves and increase profitability.

 
 

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