Stress Testing in the US: What Happens Next?

The wind continues to blow, the waters churn, and the stress testing storm rages on. More and more banks are being pulled into the fray. With regulations and requirements continuing to roll in, the risk, finance, treasury, and IT departments at banks are working towards greater collaboration on finding the best course forward.

Given that stress testing in the US is here to stay, the question on everyone’s mind is “what’s next?”

The greatest forces driving stress testing throughout the banking industry are the regulatory-mandated stress tests – principally the Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress Test (DFAST) exercises. As banks prepare for the third year of the annual CCAR process, there appears to be little reason to expect much change for the foreseeable future.

In a recent statement, William Dudley, President of the Federal Reserve Bank of New York, said that the Fed is unlikely to change course anytime soon as they see signs that the US economy is improving, but that there are strong factors slowing down the speed of the recovery. Dudley said, "We must push against these headwinds forcefully to best achieve our objectives,” as the US has yet to show “any meaningful pickup” in momentum.¹

Given the status quo of the economy, it is unlikely that regulators will soon relax the CCAR/DFAST annual and CCAR mid-cycle mandates.

As for the makeup of the scenarios in the exercises, aside from incremental tweaking, there should not be significant change:

• Generally speaking, the largest banks have managed to perform the required tests for the first two years
• Regulators are reluctant to make significant changes to the structure of the scenarios, as they would lose the ability to make year-over-year comparisons of the results

That said, the mid-cycle stresses contained several interesting idiosyncratic features that point to an increased focus from the industry on tailoring stress scenarios to their own business models and risk exposures.

Finally, from a political standpoint, one of the few things members of Congress on both sides of the aisle agree on is the need for continued regulatory supervision of the financial services industry. Here is yet another reason that stress testing regulations will stay as is, or increase. Pressure for improved analytics, governance, and infrastructure, and the continuing stream of regulatory “Matters Requiring Attention” (MRA), will continue to drive banks to seek better and more comprehensive practices.

As Basel III approaches, regulators will introduce two components to guard against liquidity risk: the Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). The requirements of these two ratios will ensure that banks hold enough high quality liquid assets to survive stress periods and have secure sources of long-term funding.

Similar to the CCAR/DFAST exercises, these measures aim to address the problems that caused the financial crisis by offering more insurance against the possibility of major bank collapses. And for banks to address the liquidity risk requirements, they must carry out more frequent and rigorous stress tests and scenario analyses to ensure they can survive extreme market conditions.

The evidence of the brewing liquidity changes can be seen with the September 19, 2013 release of the proposed Complex Institution Liquidity Monitoring Report (FR2052a) and its less complex twin, the Liquidity Monitoring Report (FR2052). With these new monitoring reports, the Federal Reserve continues to take a somewhat different, and much more active approach, than some international regulators and the Basel Committee pronouncements.

As with the CCAR/DFAST exercise, it is likely that the foreign supervisory authorities will follow a similar path around liquidity risk. This is perhaps more likely given that, like the stress tests and DFA Section 165 enhanced prudential standards, the new liquidity monitoring standards apply not only to domestic banks, but also to foreign banking organizations. Moreover, with the December 2012 issuance of SR 12-17, Consolidated Supervision Framework for Large Financial Institutions, the Federal Reserve has established, as a core supervisory principal, enhanced capital and liquidity management to increase the resiliency of banks and the broader market.

During the first CCAR exercises two years ago, banks cobbled together largely manual processes and Excel-based data to run the tests they reviewed with the regulators. Slowly, firms began realizing that they need to streamline and automate their stress testing processes to be effective. They also understood that integrating and bringing consistency between and across the risk, finance, and treasury operations business lines are critical.

Figure 1 provides an overview of the maturity levels in stress testing. Most banks have launched some form of a stress testing program; yet, many still have not advanced past the “Responding to regulation” stage of stress testing maturity.

Meeting the CCAR/DFAST and liquidity stress testing requirements, as well as raising the quality, consistency and transparency of various financial and operational risk, as required by the Dodd-Frank Act, is driving banks to collect, analyze and report more detailed data to regulators, auditors, management and customers.

To meet these requirements, banks need to address the challenge of establishing real-time visibility, analysis, and reporting of enterprise-wide data. Many banks need to transform their existing IT infrastructure rather than simply reacting to regulations on a case-by-case basis. Instead, banks are being driven to come up with a well-designed plan to transform their IT infrastructure and operations to meet current (and future) mandates.

Figure 1. Overview of maturity levels in stress testing

Source: Moody's Analytics

Some organizations are aggressively consolidating their systems, seeing the need for regulatory compliance as an opportunity to fix systems that may not be working optimally. An improved IT infrastructure can help banks drive down both the time and cost of maintaining regulatory compliance and, at the same time, enable them to expand resources, expertise, intelligence, and visibility across the enterprise.

Initially, banks took a tactical approach to the stress testing requirements. Now many banks have shifted their focus to an effective stress testing process.

One of the pressing questions for many banks involved in the regulatory stress testing exercise is how to best use the investments necessary to create the required stressed measures.

Is the stress testing exercise just a regulatory compliance process or can it increase enterprise value through the creation of effective stress testing tools? The regulatory authorities clearly hope that the stress testing framework and resulting analytics are used to drive business decisions. It is unclear, though, how the information derived from the stress testing exercise will affect those business decisions.

The stressed measures themselves, while helpful with understanding hypothetical capital shortfalls under severe economic conditions, are not necessarily the same measures a bank would use to guide decision-making under routine operating circumstances. Due to the significant costs involved in gathering, validating, and remediating the required data, and integrating various business processes in support of the stress testing exercise, it is important to consider how these investments will pay dividends for normal bank operations not merely as a stressed capital assessment tool.

As a starting point, it is clear that for the stress testing data and models to be useful, they must be leveraged by the underlying businesses that generate or originate risk. This implies that the systems and processes that are built to support the stress testing exercise should be designed in a manner that allows the same infrastructure to support ongoing risk assessment, including riskbased pricing and performance management. Perhaps, this includes many of the DFA 165 enhanced prudential standards.

The key ways in which banks can generate additional business value include:

• Enhancing forecasting capabilities around credit-adjusted new business volume
• Increasing their ability to assess returns on capital after stress
• Linking infrastructure and models to front office credit decision and pricing tools
• Boosting their ability to assess exposure to idiosyncratic shocks to industries, geographies, and pools of credit exposure

Banks may not yet have a clear idea of how to leverage their efforts to satisfy the regulatory stress testing requirements, but perhaps they can take solace by considering the "Moneyball" concept that revolutionized Major League Baseball. Moneyball challenged the tried-and-true wisdom of baseball insiders, and instead offered an analytical and evidence-based approach to assembling a competitive baseball team. There may well be great enterprise value in the tools banks are building for stress testing – they may just need to find a new way to take advantage of the changes in their approach to stress testing.

In any case, the stress testing storm will continue and it will be anything but smooth sailing in the short term for banks in the US. The regulatory stress testing and reporting mandates will continue, and the pressure to implement integrated and automated stress testing solutions will push banks to refresh their IT infrastructure.