PRIMER: Dodd-Frank and stress testing

Author: John Crabb | Published: 22 Sep 2017
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What is stress testing?

Stress testing is a form of assessment used to determine if financial institutions have the necessary capital requirements to withstand the effects of various potentially damaging economic scenarios. Bank capital is defined as its net cash, loans and securities. 

Banks, and other financial companies, look at their balance sheets and simulate a number of economic events, taking into account what has already happened, what kinds of things will happen to their portfolios if adverse events occur, and whether they have robust enough capital levels to cope with these situations.

Why is it necessary in the United States? 

It is widely accepted that the 2008 financial crisis came as a result of a liquidity shortage caused by over lending in the US home mortgage securities sector. Banks offered mortgages and loans to borrowers who could not afford the repayments, eventually leading to a default that had disastrous effects on bank capital.

In 2010, two years later, the Obama administration passed the Dodd–Frank Wall Street Reform and Consumer Protection Act, passing control of the financial system to the government, and introducing several provisions designed to prevent future risk. In an attempt to prevent a repeat of the very circumstances that led to the crisis in the first place, Dodd-Frank introduced provisions for bank stress testing to monitor banks capital levels. 

Section 165(i) of the Act provides that the appropriate primary financial regulatory agencies, and the Federal Insurance Office have to conduct annual stress testing on non-bank and banking financial institutions to evaluate if they 'have the capital, on a total consolidated basis, necessary to absorb losses as a result of adverse economic conditions’.

Although important, mortgages are only one piece of the puzzle. Stress testing looks at a set of assumptions across many additional sectors including the labour and the capital markets. These markets become constrained within certain parameters, and if an adverse event happens, there is a need to evaluate what happens to losses and what effect this has on the institution’s portfolio. 

Who has to undergo stress testing in the US? 

In the US banking system there are two types of stress testing that institutions have to perform, to prove that they can handle the duress that any situation may throw their way. 

Under the supervision of the Federal Reserve Board of Governers, the comprehensive capital analysis and review (CCAR) complements Dodd-Frank stress testing. It is however separate as they are run in coordination to avoid repetition. It looks at an institution’s 'capital adequacy, internal capital adequacy assessment processes, and their individual plans to make capital distributions, such as dividend payments or stock repurchases’.

The Fed administers a number of forward looking tests to bank holding companies (BHCs), US intermediate holding companies (IHCs), savings and loan holding companies, state member banks, and non-bank financial institutions, as determined by the Financial Stability Oversight Council (FSOC). CCAR is limited to financial institutions with $50 billion or more of consolidated asserts, of which there are currently 34. According to the Fed:

'[Its] expectations for capital planning practices are tailored to the size, scope of operations, activities, and systemic importance of a particular firm.’ 

The second type of stress test is run bi-annually by financial institutions that hold total assets of $10 billion or more, using similar methodology but under strict reporting rules. The institutions must publish the results of these stress tests on a specific date based on their assets, and they are available to the public. 

What are the scenarios of a stress test? 

The scenarios that these institutions are tested on are baseline - the actual situation or status quo - a situation used in the beginning of all exercises, as well as adverse and severely adverse scenarios that imply a different level of global recession.

These scenarios include several economic variable possibilities; macroeconomic activity such as inflation, unemployment, gross domestic product, exchange rates, income deviation and interest rates"

These scenarios include several economic variable possibilities; macroeconomic activity such as inflation, unemployment, gross domestic product, exchange rates, income deviation and interest rates. The latter of the three are purely hypothetical situations.

So why is this up for debate? 

The stress testing process gives an improved picture of the capital that the banking institution has and how much capital it is going to have in times of stress. However, because it’s based on a set of increasingly hypothetical variables, while it may paint a positive picture, how good that picture is is or how accurate it is entirely open to debate. Outcomes will be different if the assumption is that house prices are going to go down by five, 10 or even 40%.

"You have to realise you are making a lot of assumptions that may or may not be warranted, and may be debatable," said Oliver Ireland, partner at Morrison & Foerster. "The numbers that are being used to do that stress testing can be exaggerated numbers, or simply the wrong ones. Some of them are better than they should be, some of them are worse than they should be." 

There is a sense that there is a false precision to those stress tests and some of the assumptions that are the basis of them aren’t warranted, he said.

Other adversaries to the process suggest that stress testing has become laborious, overly time consuming and expensive. The process of bank stress testing has become overly complex, and no longer achieves the intention it was originally designed to do. 

What does the current administration think of stress testing? 

President Trump is a vocal adversary of Dodd-Frank and much of what it stands for, including stress testing. Less than two weeks after his inauguration he released an executive order calling on the Secretary of the Treasury, Steven Mnuchin, to report on whether all key US rules and regulations inhibit the progression of the US economy, and laid out his Core Principles by which the financial system shall henceforth be governed.  

In response to this, Mnuchin released in June his report to Trump looking at the banking sector, A Financial System That Creates Economic Opportunities. In this the Treasury suggested a number of recommendations allowing for tailoring of the stress testing parameters. The provisions are 'aimed at both decreasing the burden of statutory stress testing and improving its effectiveness by tailoring the stress-testing requirements based on the size and complexity of banks’. 

For company led testing, for example, it recommends raising the participation threshold from $10 billion to $50 billion, and allowing the regulators flexibility to tailor thresholds depending on circumstances, so that those with greater balance sheets may also be exempt in certain situations – business model, balance sheet, and complexity. 

The Treasury also recommended removing the mid-year stress test cycle and the adverse testing scenario, and allowing banks to make their own determinations for the FED led tests. 

CCAR, it also suggested, is too subjective and should not be used as an objection to a financial institutions capital plan. 

So where are we now? 

Not long after this report was released, all 34 of the US’s biggest banks passed the stress tests for the first time ever, meaning they all hold enough capital according to its stipulations. Capital One Financial was asked to address certain weaknesses in its capital plan, and has six months to do so. 

Banks can raise capital, and arguably reduce their potential for failure due to loan losses, but in doing so are also raising the cost of borrowing in the economy, said Ireland. Fed policy since 2008 has encouraged borrowing by maintaining low interest rates, but at the same time has a bank capital policy that discourages lending. 

"Are the numbers too high?" said Ireland. "If everybody passes the stress test, well that is wonderful, but if the interest rates are too high, then it is having other effects on the economy." 

It is likely that if the current Administration remains in place for the foreseeable future, stress testing will be radically changed to allow banks to take greater risks, whether this is sensible or not is a question of politics, not law. 

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