Bank Stress Capital Planning: Importance Of Qualitative Metrics

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Includes: FAS, FAZ, IYF, UYG, VFH, XLF
by: NewOak

By Ron D’Vari

While banks have significantly increased dedicated resources to improve and even revamp risk management and capital planning processes, regulators have steadily increased the required standards for process governance, control and validation for stress testing and reporting.

‎Regulators have rejected several bank holding companies' (BHCs) capital plans due purely to qualitative reasons, even though they passed quantitative components. Regulators also have made the stress scenarios more challenging every year. Recent supervisory adverse scenarios have included a flat yield curve combined with higher peak inflation and faster declines in the equity and housing markets.

‎Dodd-Frank Act Stress Test (DFAST) results for 2015 showed all 31 reporting U.S. BHCs passing minimum capital ratio requirements quantitatively, with DFAST assuming current dividend levels.‎

‎Comprehensive Capital Adequacy Review (CCAR) encompasses BHCs' projected capital actions such as increases to dividends, share repurchases and capital raises. CCAR ‎measures impact of supervisory scenarios on the regulatory capital ratios of BHCs by projecting the balance sheet, risk-weighted assets and net income over nine quarters.‎

‎‎The CCAR framework requires estimation of pre-provision net interest and revenue by projecting net interest income plus non-interest income minus non-interest expense, referred to as PPNR. It also accounts for projected losses due to operational risks (e.g. litigation expenses, fraud, operating disruptions, mortgage repurchases and expenses related to the disposition of foreclosed properties). ‎Credit risk includes: a) loan losses and changes in the allowance for loan and lease losses, b) losses on loans held for sale and measured under the fair-value method, and ‎c) other-than-temporary impairment losses on investment securities.

‎‎For BHCs with large trading, prime brokerage, custodial and private equity exposures, losses connected to a global market must also include losses from these activities (market risk) and default of their largest counterparty (credit risk combined with market risk).

‎Some of the key qualitative factors include: model and non-model development processes, soundness of data capture and infrastructure, depth of champion/challenger model validation and testing process. The regulators pay attention to how the stress test models reflect and capture the realities and past performance of the BHC and the depth of top management understanding and use of those models and relevant data in making capital and business decisions. The process should capture firm-specific vulnerabilities and risks in projection of revenues, expenses, losses and risk-weighted assets. Bank senior management must actively use and validate forward-looking projection models to comprehend and anticipate cause and effect of risks and revenues under different dynamic scenarios. Once a BHC makes a real commitment to institute a robust and well-controlled governance process and implement it, they find the benefits go beyond just satisfying the regulatory requirements. Citi (NYSE:C) is a good example of an institution that initially failed the qualitative component but was praised for its process in 2015.