CCAR stress testing – US banks have passed the muster-FBO’s will join the flock

CCAR (Comprehensive capital adequacy and review) has become annual ritual among large bank holding companies in US since 2011. Every year banks submit their capital plans to regulator (Federal Reserve). Afterwards Banks wait anxiously till March when fed announces whose capital plan got approved or rejected. Due to its implications for capital distribution including dividends has gotten stock markets interested in this comprehensive exercise to add some excitement. In 2015, we have seen 28 of 31 banks have gotten it correct and happily distributed dividends. Two banks (Deutche bank and Santander) failed for qualitative reasons. Now from January 2017 onwards we will see more banks will take part in this annual gala festival of stress testing. This increase will come mainly from foreign banking organizations. So can they learn something from experience of large bank holding companies to get them pass the stress testing. So what is it? Where do they focus? CCAR stress testing – US banks have passed the muster-FBO’s will join the flock
Banks (Foreign Bank organizations (FBO)) need to assess their US (United States) assets and Global assets to determine the stringency of US prudential standards. Davis Polk & Wardwell LLP has provided a good visual for this.

FBO’s must implement Intermediate holding company (IHC) by aggregating assets of all its US subsidiaries. IHCs must submit their capital plan to Federal Reserve on January 2017 as a part of compliance. Compliance to Federal Reserve is not as easy as it is said. Fed will evaluate capital plans for both quantitative (capital ratios) and qualitative (Governance, Internal controls, Aggregation, Model risk management and others) aspects.

Quantitative factors

Among banks that have passed the Fed stress last few years most of them. The Federal Reserve did not object to any plans based on quantitative grounds.

• “U.S. firms have substantially increased their capital since the first round of stress tests led by the Federal Reserve in 2009. The common equity capital ratio--which compares high-quality capital to risk-weighted assets--of the 31 bank holding companies in the 2015 CCAR has more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 percent in the fourth quarter of 2014, reflecting an increase in common equity capital of more than $641 billion to $1.1 trillion during the same period”
• In the CCAR quantitative assessment, the Federal Reserve evaluated each BHC's ability to take the capital actions described in the BHC baseline scenario of its capital plan and maintain post-stress capital ratios that are above a 5 percent tier 1 common capital ratio and above the applicable minimum regulatory capital ratios in effect during each quarter of the planning horizon”
This means FBOs as long as they meet the minimum criteria for the capital ratios they will be fine.

Qualitative factors

In general fed rejected capital plans citing qualitative factors for various banks. This year they have rejected Deutche bank capital plan citing flaws in regulatory aggregation and reporting process. In earlier years they have rejected capital plans citing lack of proper internal controls or weak modeling practices etc. In some other cases FED issues MRA (matter requiring attention) or MRIA (Matter requiring immediate attention) where they find problems. Furthermore, Fed has issued in August 2013, a range practice paper discussing observed practices (Leading/lagging) and best practices. Banks that are thinking of complying with Feds requirement should pay heed to this publication. They can also deploy experts who understand these practices to get an understanding. FBO’s in general face significant challenges in the area of modeling revenues, projecting stress losses, aggregation of loss and revenue estimates, Model risk management and internal controls. This is because, for the subsidiaries within FBO;s in general not having uniform industry leading practices is not uncommon. This happens for variety of reasons.
Therefore FBO;s need to standardize the process across various entities and then aggregate the final outputs at IHC level. FBO;s first need to assess its current practices across various dimensions. For instance in the area of model risk management, Fed requires them to have a model risk management policy in place to govern the model development associated validation and finally a rigorous review by internal audit. FBO should have governance structures at IHC level to coordinate these activities among the subsidiaries. When it comes to data governance and aggregation at IHC level FBO’s should leverage BCBS 239 regulatory initiatives for leading practices.