The Dodd-Frank Act Stress Testing, prescribed by the Dodd-Frank Wall Street Reform and Consumer Protection Act, requires national banks and federal savings associations with more than $10 billion in assets to conduct annual stress tests. When finance professionals mention capital stress testing, most are referring to DFAST instead of the complementary testing through the Comprehensive Capital Analysis and Review. CCAR is advocated by the Federal Reserve and applicable to bank holding companies with assets greater than $50 billion.
Although not directly impacted by DFAST or CCAR, the NCUA has mandated a similar protocol (e.g., submitting capital plans and performing capital stress tests) for credit unions with $10 billion or more assets, with some differences in deliverables and timing of submission. The purposes of capital planning and stress testing are to assess whether institutions have adequate capital to survive periods of severe economic turmoil. Although the process of developing such initiatives can be costly and burdensome, every institution, regardless of asset size, should perform both.
Developing scenarios and reporting them to regulators can be costly and time-consuming. The Federal Reserve provides direction, but it can be challenging to develop reasonable scenarios beyond the Fed's basic guidelines. Nonetheless, performing stress tests is important for institutions to protect their capital and assist management in determining future initiatives.
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Capital stress testing is a thorough process considering many facets of an institution and the potential risks facing it. These tests are mechanisms allowing stakeholders to clarify risk tolerance, inform and direct forward-looking strategic plans, and evaluate exposures through quantitative and qualitative lenses. The scenarios performed in capital stress tests are theoretical and intended to push an institution to the brink of failure. In addition to providing guidance for future planning, the scenarios can assist in solving actual pain points within organizations, but management must be willing to devote appropriate resources.
Elements of Capital Stress Testing
Data management: For most institutions, the first hurdle in setting up a capital stress-testing program is data collection and implementation. Many fail to capture critical data beyond loan origination, severely diminishing the returns gained from the process. Data governance is not only critical for stress testing, but should be a priority for the institution as a whole. The ability to analyze the credit union's profitability, value and overall risk relies on the availability of data. Creating a true data governance program gives the credit union confidence in its analyses, allowing managers to make decisions using supported information, rather than relying on reports with weak assumptions.
Loss and recovery assumptions: A substantial portion of capital stress testing is the assumption of principal losses and recoveries. Given the economic changes projected in Federal Reserve scenarios, institutions need to make assumptions about the loan portfolio's default tendencies. Charge-off history and delinquency trends should be utilized for each collateral type. Every institution should know the delinquency rate of different portions of the portfolio and the lag between default and principal recovery. Modeling principal recoveries assuming immediate recovery won't capture reality. In times of economic crisis, recovery lags can extend significantly, further emphasizing the importance of such knowledge. Credit unions should know the cost to foreclose upon or repossess collateral, as both are vital in making strategic decisions regarding product offerings and risk-based pricing.
Scenarios: Exercises such as DFAST, CCAR, and NCUA-guided capital planning and stress testing enable institutions to simulate their position in extreme environments. These simulations should be a standard practice for all financial entities. Risk is the existence of unknown factors, which may ultimately affect the valuation of an institution. Depositories are compensated for accurately pricing risk and assessing value for risky assets through scenario analysis.
Scenario testing should go beyond balance sheet risk and valuation. Depositories have a unique structure in that liquid, short-term liabilities fund long-term assets. Consequently, they carry significant liquidity risk. Liquidity scenarios should incorporate local economic events, global economic events and isolated risks, which may be difficult to capture in traditional modeling.
Analyses: To inform the projections used in alternate scenarios, institutions should perform regression analyses on performance and changes in macroeconomic variables. This makes it easier to understand sensitivity to economic factors. The credit union's analyses should include unique scenarios that aren't market-related and, therefore, not part of traditional modeling.
Communication: All testing and reporting should be frequently communicated to management and the board of directors. Capital planning and stress testing should be highly transparent and easily audited, with a focus on reporting key variables and the credit union's sensitivity to such variables. That means incorporating credit monitoring, liquidity planning and profitability into strategic planning discussions to guide the institution's future.
While it can be costly and time-consuming to perform these extensive exercises, the reporting and analyses required by regulators should already be incorporated, to some extent, in every credit union's daily management. The failure to do so can put every institution at a significant disadvantage.
Thomas Griswold is director, Strategic Solutions Group for ALM First Financial Advisors, LLC. He can be reached at 214-451-3491 or [email protected].
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