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The Fed’s Comprehensive Capital Planning and Review (CCAR) continues to be a barometer for capital adequacy of large banks in the US. With the results of the 2016 DFAST now in the books, we look at factors that will impact the Fed’s CCAR decisions next week and the challenges that firms will face in the future.

The 2016 supervisory severely adverse scenario was particularly challenging for the industry since it combined a downturn as severe as the Great Recession with negative short-term interest rates. As explained by Mark Zandi, our Chief Economist, “The narrower the [Treasury yield] curve, the more difficult it is for the banking system to lend at a profit, as its cost of funds is tied to short rates and its lending rates to long-term rates.” The severity of the scenario also presented challenges since the banks’ internally generated scenarios used for the capital plan submission must be as severe as the supervisory severely adverse scenario. The tight timeline associated with the DFAST/CCAR process coupled with scenario translation, result generation, and overarching governance process continue to make the scenario “surprises” operationally straining.

In addition to the unique stressful economic scenarios the Fed develops, there are some recurring themes that we have come to expect from the CCAR qualitative and quantitative reviews. As a quick CCAR refresher, each large bank ($50B+) is required to submit a capital plan that details their planned capital distributions, and the supporting information used to make these decisions. The Fed reviews these plans and can object to an organization’s planned capital distributions either on the grounds of (1) the quantitative stress test or (2) the qualitative review of capital planning and risk management (see Figure 1 below for trends in supervisory decisions).

The qualitative review will continue to be the driver for capital plan objections

  • As evidenced by the DFAST results, large banks continue to strengthen their balance sheets by building their capital base. For 2016, fewer banks are in jeopardy of missing the mark identified by the Fed for the quantitative portion of the stress test.
  • The Fed has continued to apply pressure on large banks to improve their risk management and capital planning. The review focused on banks’ modeling, internal controls, and governance of the capital planning process. Specifically, new areas of focus for 2016 will include material risk capture, frequency of risk review, and ongoing risk monitoring, and how these aspects link to the capital planning process.

Tailoring of supervisory expectations will impact the review

  • Newly issued supervisory guidance split the legacy CCAR universe of firms into two categories: (1) Large and Complex and (2) Large and Non-Complex. The Fed has signaled they will review the Large and Complex Firms with more scrutiny.
  • All firms will face additional scrutiny on the coordination of their stress testing framework and how it links to their risk identification process. Firms deemed Large and Complex face heightened expectations for loss modeling, risk management activities, and senior management governance of the process.

What to expect going forward

  • Fed Governor Daniel Tarullo has recently mentioned possible changes to the CCAR process. It’s likely that future CCARs may only include firms deemed “Large and Complex”. Capital planning reviews for “Large and Non-Complex” will still be conducted by regulators, but the process may more closely resemble the Fed’s 2012 and 2013 Capital Plan Review for new entrants (CapPR) or the Fed’s Liquidity Stress Testing review for firms not supervised under the Large Institution Supervision Coordinating Committee framework.
  • Firms are looking for ways to make their stress testing process part of business as usual, partially in response to the capital planning guidance. Expect to see ongoing investments in infrastructure that improve cycle time, help coordinate stress testing with risk appetite monitoring, empower more scenario analysis, and provide actionable information to management in a timely fashion. This will enable firms to more efficiently leverage their stress testing framework for computing expected credit losses under the new allowance standards (CECL/IFRS 9). Additionally, it will allow for greater coordination between capital planning, liquidity planning, and resolution planning.
  • There is no shortage of unique stress scenarios the Fed may choose to include in future stress tests, but firms are also being pushed to improve their process for developing internal scenarios that reflect the specific vulnerabilities of their business model. Future BHC stress scenarios will need to incorporate all material risks and “knock-on” effects, as well as other unexpected nuances (such as negative interest rates introduced in the 2016 Fed scenario) in a compressed time horizon. Firms will also be pushed to incorporate more “what-if,” alternative scenarios in the future.
Figure 1. Adverse Actions on Capital Plans
Adverse Actions on Capital Plans
Source: Moody's Analytics

While the DFAST results are always interesting and provide information on the Fed’s modeling process, the Fed’s CCAR decisions released next week will have a more significant impact on the market. Two items to look for are capital plan objections and conditional non-objections. These identifiers mark firms the Fed has determined to have risk management weaknesses that may limit their ability to pay capital distributions. Stay tuned for our follow-up analysis of bank versus Fed model differences in an upcoming session in July 2016.

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