Risk Review: CCAR

Risk Review Comprehensive Capital Analysis & Review, CCAR: What does it mean for you?

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INTRODUCTION Welcome to the very first

importance of having a

edition of Risk Review this

comprehensive stress testing

year. As we edge closer

program is being constantly

to RiskMinds Americas,

validated by the world we

taking place in Chicago

live in.

this September 20-23, the last few months have been reminders of just how unpredictable and turbulent the global geopolitical and macroeconomic climate can be.

With our lives being influenced by Brexit, an

It is the significant depth and breadth of content that marks RiskMinds Americas as a unique forum and it is our aim that this magazine will help to build on our quality, timely content made possible by our growing community.

impending new U.S. President and negative interest rates, to name just a few challenges, it is fundamental for risk managers to be aware of every possible risk eventuality and the potential implications

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these factors will have on our evolving financial landscape.

The topic of CCAR is therefore especially timely for us to be addressing in Risk Review this quarter. This is not only

Ed Stapley,

because of the necessity

Editor-in-Chief,

for banks to get to grips

RiskMinds

with the specifics of today’s regulatory frameworks, but fundamentally the

CONTENT INTRODUCTION

Page 2

THE ORIGINS OF CCAR

Page 4

STRESS TESTING

Page 6

DIFFERENCES WITH OTHER CCAR TESTS

Page 8

THE CHALLENGES

Page 10

THE ORIGINS OF CCAR

BY LYNN STRONGINDODDS

The global financial crisis shook the

DFAST test because it relies on the

banking industry to its core and the

yearly supplied CCAR scenarios. If

ramifications are still reverberating

they are submitting both they must

today. However, the US banking

do it at the same time.

system is much more robust and resilient today than it was before

There are also variances to the stress

2008 thanks to a tighter regulatory

testing. While the DFAST assesses

framework imposed by regulators

whether a BHC has sufficient capital

across the globe.

to absorb losses and continue operating in severely adverse

In the US, key planks in the Federal

conditions, the CCAR evaluates the

Reserve’s programme are the

business’ policies and strategies

Comprehensive Capital Analysis and

for effectively handling various

Review (CCAR) and the Dodd Frank

scenarios.

Act stress testing (DFSAT). They both put banks through their paces

As for the logistics, the larger banks

in the shape of an annual stress

have to submit DFAST worksheet

testing exercise. The aim is to assess

with each year’s CCAR worksheets

whether the banks have sufficient

while their smaller counterparts –

capital to continue operations

those BHCs operating between $10

throughout times of economic

and $50 billion only have to submit

and financial stress.

a DFAST worksheet.

Difference between CCAR and DFAST: CCAR and DFAST are two complementary components of the federal government’s assessment of a bank holding company’s (BHC) stress resilience. One of the main differences between the regulations is the size of the institutions – the CCAR applies to bank holding companies with assets over $50 billion while the figure is $10 billion for DFAST. However, even the smaller BHCs must have at least partial knowledge of CCAR legislation to complete their

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5

STRESS TESTING

The driving force behind CCAR

handle a future economic shock.

recession or mild deflation that

is the collapse of Lehman Brothers

They test the bank’s ability to

causes weakened economic activity.

in 2008 and the systemic risk that

remain “well-capitalised,” with a

Last but not least is severely adverse

swept across the world’s banking

minimum Tier 1 common equity

–a theoretical situation involving

sector. The legislation substantially

ratio of 5%, even in a severely

a severe global recession with

strengthens the Fed’s approach

negative economic scenario.

U.S. unemployment rates rising

of ensuring that large BHCs have

to 10, a heightened period of

thorough and rigorous processes

The qualitative review is also an

corporate financial stress, and

for managing and allocating their

important component and has

negative yields for short-term U.S.

capital resources. Large, complex

accounted for the majority of

Treasury securities.

BHCs are expected to hold sufficient

the Fed’s capital plan objections

capital in order to maintain access

over the last three CCAR cycles. It

to funding, play a role as credit

focuses on risk management and

intermediaries, meet their obligations

governance of the capital planning

to creditors and counterparties, and

process of each CCAR firm. Key

to continue operations, even in an

items evaluated include data quality,

adverse environment.

risk identification, forecasting processes, capital policies, and

In the pre-CCAR era, firms looked

internal controls to ensure the firms

to simulation-based approaches

have a sound capital adequacy

to analyse millions of scenarios,

process. Management’s dividend

calculate risk-based capital

and share repurchase decisions is

requirements and manage portfolios.

also scrutinised to see whether there

Although the numbers crunched were

is enough capital retained to cover

sound, some of these approaches

risks in a stress environment.

were a bit abstract and often difficult to interpret for senior executives.

Not surprisingly, the scenarios vary from year to year so they aren’t

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Today, the new rules require stress

too predictable although they are

tests to be submitted according to

broken down into three categories.

several macroeconomic scenarios

Baseline is predicated on the average

provided by the Fed, and are used

projections of economic forecasters

as protection to check for whether

while adverse is a hypothetical

a bank’s system could theoretically

situation involving moderate

Institutions continue to have material unresolved supervisory issues that critically undermine its capital planning process

All participating BHCs are expected

regional player Huntington

shareholders unless expressly

to create two of their own scenarios

Bancshares of Ohio could keep

authorised. The Fed had previously

and supply actions plans. One must

trading with capital above the

noted banks that demonstrate a

be based on baseline expectations,

regulators’ minimum levels.

chronic inability or unwillingness to

where the other uses a stress

correct deficient behaviour can also

scenario, meaning that each BHC is

Only two banks failed this

be subject to enhanced regulatory

required to submit action plans for

year - Santander Holdings USA

actions, including but not limited to

five total scenarios. The exam also

and Deutsche Bank Trust Corp.

cease-and-desist orders. However,

requires every mandated bank to

The results marked the second

Santander and Deutsche Bank are

submit a “capital action plan” for the

consecutive failed test for Deutsche

seen to have made progress and are

following four quarters. The Fed then

Bank, and the third straight year

committing more resources to the

assesses that bank’s financial health

that Santander has flunked. While

stress-testing process.

and gives the bank a score. This is

both foreign-owned banks met the

not simply a “pass/fail” assessment

minimum regulatory capital ratios

The stress-testing struggles being

but banks are graded in terms of

that are required by the Fed, they fell

encountered by Santander and

exactly how strong they are.

short on qualitative grounds, just as

Deutsche Bank do not reflect the

they did in 2015.

experiences of all foreign-owned

The Latest Round

banks. For example, BBVA Compass,

The latest round of stress tests in

The regulator noted that the

BMO Financial, HSBC North America

June 2016 showed that the largest

institutions continue to have

and MUFG Americas were among

US banks would be able to withstand

“material unresolved supervisory

those that passed as did first-time

the worst case scenarios. Every one

issues that critically undermine

participants BankWest Corp. and TD

of the 33 institutions that took the

its capital planning process. These

Group US Holdings, both of which are

first part passed which meant that

included deficiencies in risk-

also owned by foreign banks.

they not only built up significant

management processes and stress-

Four additional foreign banks –

capital since the 2007-2009 financial

testing processes. The key question

Barclays, Royal Bank of Canada, UBS

crisis but that management teams

now is what the consequences will

and Royal Bank of Canada – are

have largely proven the merit of their

be for repeated failures. Santander is

expected to be included in CCAR

internal disaster planning to the Fed.

the first bank to fail CCAR for three

starting in 2018.

Even if total losses over a nine-

years in a row.

quarter period reached $385bn, the test revealed that the banks ranging

One punishment for failing the

from Wall Street power house

test is not being allowed to make

JPMorgan Chase to heavyweight

any capital distributions to their

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DIFFERENCES WITH OTHER CCAR TESTS

international operations to the

They note that “our assessment of

effects of a commercial real estate

the cost of likely CCAR changes,

bubble for those with large loan

incorporating a “cost of stress”,

portfolios in the sector. Additionally,

limited capital actions and GSIB

the Fed will focus on transparency

Method 2 (the estimates for the

of the end-to-end capital planning

capital surcharge) translates to an

process, from loss modelling for

incremental 75-150 basis points of

various portfolios to dividend pay-

required common equity tier (CET)

According to Moody’s Analytics

out decisions.

1 for Bank of America, Citigroup,

Ed Young, Senior Director on

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JPMorgan Chase and Wells Fargo.

the Stress Testing and Capital

A tougher stance

Our analysis now uses the 2016

Planning Team and Anna Krayn,

Eight banks that are deemed to

DFAST cost of stress as a starting

a Director, responsible for business

be global systemically important

point and relies on existing forecast

development for stress testing and

bank holding companies (GSIB)

RWA changes and capital actions.”

capital planning solutions, while a

will face a more onerous

majority of the items the Fed covered

examination in the next round

Their research also assumes that the

in the qualitative review were similar

in 2018. They will be required to

CCAR is then the binding constraint

to past CCARs, there were a few

incorporate capital surcharges

on capital and relative to current

differences.as the enterprise-wide

ranging from 1% to 3.5% of their

non-stressed required fully-phased

stress testing processes mature

total risk weighted assets into

in Basel 3 CET 1 minimums.

across the industry.

their minimum capital thresholds.

In the past, expectations revolved

They include JPMorgan Chase, Bank

around loss modelling, capital

of America, Wells Fargo, Citigroup,

policy, and model risk management

Goldman Sachs, Morgan Stanley,

processes. This year the focus has

Bank of New York Mellon and State

been on risk identification, process

Street. The aim is to increase capital

integration, and scenario design.

requirements to a level at which

“In other words,” they point out,

banks consider selling assets and

“the Fed will be trying to determine

relying less on wholesale funding.

if each bank has its arms around

The changes could hurt profitability

all of the different types of risks it

for banks’ profitability, according to

may face, from extreme currency

Credit Suisse analyst Susan Roth

fluctuations for firms with extensive

Katzke and her team.

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THE CHALLENGES As the tests indicate, banks are

that they have sufficient capital

However, despite the improvements

generally in a much healthier state

available to operate soundly even

in data quality, analysis and loss

than they were eight years ago and

under extreme economic duress,

modelling for all large banks, the

better equipped to weather most

and whether or not they have what

three analysts contend that there is a

unexpected storms. However, as Ed

the regulator calls “a robust, forward-

need for additional scenario analysis

Young is a senior director on the

looking capital-planning process”

beyond the Fed’s small set of

stress testing and capital planning

that accounts for their unique risks.

deterministic scenarios (i.e., baseline,

team at Moody’s Analytics, argues,

Meeting these requirements has not

adverse and severely adverse).

“One of the benefits of the exercises

been an easy task. This is because

“Market disruptions can be driven by

is there is greater supervision to

macro-economic variables are not

a host of real or imagined threats.

ensure that banks are stronger and

easily predictable and there can

If they were not nearly impossible

more resilient, but more work needs

be an infinite number of variables

to predict, they would not be “shocks,”

to be done.”

influencing scenarios and outcomes.

they note.

This has required banks to build On the positive side, Young along

effective models that produce

One of the problems is the

with Krayn, and David Little,

accurate data, identify key risks

deterministic analysis that banks are

Managing Director, Head of the US

and respond accurately.

forced to use. Although intuitively

Enterprise Risk Solutions and Stress

it is a well understood narrative

Testing Sales Teams point out that

and cohesive framework across

the Fed has established a process

the enterprise, the negative is the

that emphasises forward-looking

inability to explore the impact of a

financial metrics to improve capital decisions as well as a standardised benchmark for the severity of an enterprise-wide stress test. In addition, banks not only have to respond to the Fed’s home-grown scenarios but also develop stress scenarios tailored to its specific risk profile.

In the past, the Fed would evaluate capital at a moment in time whereas under CCAR banks need to prove

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There needs to be a more holistic view and greater investment in operational efficiency.

broad range of possible scenarios, according to the analysts.

They also argue that while “firms have spent a significant amount of time, effort and money chasing the goal of precisely predicting the impact of a few hypothetical scenarios, precision has been emphasised much more than the need to understand a much broader set of possible outcomes. Ironically, the latter, in many cases, is the more useful tool for a risk manager.”

To rectify the situation, Young

firms to consider many possible

replace outdated ALM systems with

believes that there needs to be

outcomes without the l burden of

current, CCAR/DFAST-compliant

stronger links between these

current stress testing processes.

ALM systems which can calculate

processes and dynamic risk

As the enterprise stress testing

credit losses under various economic

management tools, internal controls

framework matures, the financial

assumptions as it generates the

and governance. “In 2015 the Fed

system will become much more

balance sheet run off, additions,

emphasised in its guidance that

resilient to economic downturns and

and income statement flows. In

banks need to continue to develop

market shocks.”

order to build the most effective

sound processes for integrating the

model though, banks must have

risks of their specific business model

The other big challenge banks

the ability to migrate economic

into their stress testing process,” he

have faced is the ability to find and

assumptions into their credit ratings

says. “This means that banks will

pull together the right information

within the ALM system, according

need to increase the number and

to meet the Fed’s requirements,

to Newcomer.

frequency of scenarios they consider

according to Will Newcomer, Vice

when making capital decisions.

President of Product and Strategy,

Conclusion

U.S. Risk & Compliance, Wolters

The CCAR is an annual exercise

The analysts recommend a three

Kluwer. “In the past many of these

by the Federal Reserve to assess

pronged approach be adopted

processes have been manual. While

whether the largest bank holding

which includes better integration

the largest banks have the resources

companies operating in the U.S.

of risk identification processes, the

and IT teams to build the technology

have sufficient capital to continue

development of a strategic planning

themselves, most of the banks have

operations throughout times of

framework and the incorporation of

looked to software vendors to provide

economic and financial stress and

a wide range of possible outcomes

the solutions.”

that they have robust, forward-

into the scenario design process.

looking capital planning process.

While these will be time-intensive

Newcomer notes though that banks

The origins are in the global financial

and costly endeavours, the end result

leveraged their asset and liability

crisis and the objective is to avoid

will be a much more robust risk

management (ALM) systems whose

a Lehman Brothers style collapse.

management tool for banks.

origins are in the interest rate

However, there are still kinks in the

deregulation era of the 1980s. They

system and some analysts believe

“There needs to be a more holistic

were originally designed to identify

a more holistic approach needs to

view and greater investment in

interest rate risk resulting from the

be adopted.

operational efficiency,” say Young.

maturity mismatch between assets

“The industry is evolving and new

and the liabilities that fund them.

tools will be developed to enable

Fast forward to today and banks can

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