Wall street journal has quoted “European banks set to fail Fed’s Test” stating regulators have found potential problems at Deutche Bank AG and Banco Santander SA and are expected to fail the Federal Reserve’s stress testing.
CCAR stress testing process is performed annually by various banks supervised by Federal Reserve to ensure banks are sufficiently capitalized. In this process banks not only need to ensure they have enough capital to absorb losses in normal times but also during stressed scenarios that include deep recession. Additionally Fed has mandated banks to provide evidence for strong compliance in the area of internal controls around risk identification, measurement and reporting, Model risk management and governance.
WSJ quotes,
“While Deutsche Bank Trust Corp. is expected to be found adequately capitalized by the Fed but will likely receive a warning on qualitative shortcomings, according to people familiar with the matter.
“Deutsche Bank Trust Corporation, which represents less than 5% of Deutsche Bank AG’s total assets, was pleased to participate” in the stress tests this year, a spokeswoman said, adding the bank “will know our results after the Federal Reserve’s announcements.”
Deutsche Bank is currently in a remediation process with the Fed over flaws in areas ranging from its regulatory reporting, risk control, monitoring and compliance systems, these people added. The bank has also been reprimanded by the Fed for flaws in its regulatory reporting, The Wall Street Journal reported last year. In a letter to Deutsche Bank executives in December, a senior official with the Federal Reserve Bank of New York said reports produced by some of the bank’s U.S. arms “are of low quality, inaccurate and unreliable. The size and breadth of errors strongly suggest that the firm’s entire U.S. regulatory reporting structure requires wide-ranging remedial action.”
At the time of the report, a Deutsche Bank spokesman said the German bank has “been working diligently to further strengthen our systems and controls and are committed to being best in class” and said the bank is spending €1 billion ($1.35 billion) globally and appointing about 500 compliance, risk and technology employees in the U.S.
A person familiar with the matter said Santander is also likely to fail for qualitative reasons, rather than because the stress test depleted its capital below regulatory minimums”
To help banks understand Supervisory expectations Federal Reserve has published best practices guide around stress testing process including internal control along with its expectations in August 2013. Additionally, In the CCAR 2015 Instructions include an appendix that summarizes common themes identified by supervisors during the 2014 CCAR cycle with respect to the qualitative element of the capital plan review.
What we are witnessing now is above mentioned two banks have significantly invested resources towards the compliance of CCAR stress testing and found to be capitalized from a quantitative perspective. Fed is coming back after its rigorous examination that the quality of internal controls and some risk measurement aspect of credit portfolios put in place for the stress testing process are not sufficient. Additionally, Federal reserve has been providing their assessment for bank stress testing plan, process and internal controls and issuing MRA (Matter Require Attention) and MRIA ( Matter Immediately require attention) to various banks to fix the problems. In response banks have been rectifying and fixing these problems.
The following eight themes came out of the CCAR 2014 program and are described further below:
(1) sensitivity analysis, (2) assumptions management, (3) model overlays, (4) model risk management,(5) capital policy, (6) presentation of consolidated pro forma financial results, (7) RWA projection methodologies, (8) AFS Fair Value OCI.
These common themes provide additional insight to the specific observations and trends, both positive and negative, which the Federal Reserve noted from its CCAR 2014 review.
Sensitivity Analysis: During CCAR stress testing process, variety of quantitative models are utilized to generate loss estimates for Trading book (Cash and derivative products), Banking book ( Credit portfolio) and other positions on the balance sheet along with Revenue model projections in various scenarios. Each of these models are developed with various assumptions and take variety of inputs ( SPX volatility, Inflation rate etc) to produce proforma estimates. Therefore it is imperative to have understanding of sensitivity of the projections to input variables and various assumptions that form the basis of the forecasting process.
Federal Reserve has noted at most banks sensitivity analysis is not conducted during the model development. Model validation function is stepping in to conduct sensitivity analysis. They are expecting banks to include in sensitivity analysis at minimum projected market share, size of the mortgage market, cost and flow of deposits, utilization rate of credit lines, discount rates, or level and composition of trading assets. However, this list is not exhaustive and conducting sensitivity testing only on these assumptions will not be sufficient to meet supervisors’ expectations in this area. If vendor models are included then sensitivity analysis becomes most important as in most cases the software code is not included.
Banks can clearly meet this requirement by including Sensitivity analysis with in their model risk management policy and make model developers to comply accordingly. Internal Audit (Model reviewers) and Model validation teams should work towards enforcing this as part of broader model risk management requirement.
Assumptions Management: Federal Reserve noted BHCs are expected to clearly document key assumptions used to estimate losses, revenues, expenses, asset and liability balances, and RWA. Documentation should provide the rationale and any empirical support for assumptions and specifically address how they are consistent with scenario conditions. Assumptions should generally be conservative, particularly in areas of high uncertainty, and should be well supported and subject to close oversight and scrutiny.
At most banks we see very clearly loss estimation methodologies and techniques are reasonably in good shape. Federal Reserve is looking for improvising the modelling approaches of the Pre Provision Net Revenues (PPNR) as they are required in the projection of capital. PPNR models utilize an array of modelling techniques including linear regression approach with assumptions around the growth of balances, deposit pricing and spreads for various products.
Banks need to establish a strong engagement of the Business and model developers to understand the dynamics the portfolio balances under various scenario conditions and Assumptions.
Model Overlays: As noted, most BHCs use some form of expert judgment— often as a management adjustment overlay to modeled outputs. In developing management overlays, BHCs should ensure that they have a transparent and repeatable process; that assumptions are clearly outlined and consistent with assumed scenario conditions; and that results are provided with and without adjustments.
Some of the banks are incorporating overlays when the quantitative models are not capturing the underlying dynamics. Often these overlays are not tied to any particular model weakness but used a general “catch-all” adjustment to influence aggregate modeled losses in the interest of conservatism.
Fed wants Banks to incorporate the impact of all risk exposures into their projections of net income over the nine-quarter planning horizon rather than trying to address certain risks and model limitations by adding buffers on top of internally defined capital goals and targets.
Most important if banks are going to have management overlays then they should have an independently Validation process to validate them. This is a must and can’t avoid this lest you will get slapped by the FED with an MRA or MRIA.
Banks can establish clear communication channels with Finance, Business and Risk and conduct the model overlay process in a transparent fashion.
Model Risk Management: Bank’s should ensure that they have sound model risk management, including independent review and validation of all models used in internal capital planning, consistent with existing supervisory guidance on model risk management (SR letter 11-7).
Fed has noted Banks have made significant progress with respect to model risk management. Most of the banks have created model risk management policy and framework to govern the development of the models and their independent validation and review. Despite having this framework and guidance modelling practices at some of the banks is not to supervisory expectations. Federal Reserve has highlighted that Banks need to improvise their practices with in the areas of Conceptual soundness and Model performance testing.
Banks have to not just create model risk management framework but also should enforce it. This will result in a strategic business if implemented correctly. Stress testing exercise is a deep dive into portfolio performance under variety of scenarios using the underlying models. Hence stress test will become litmus test for the conceptual soundness of the model along with associated outcome analysis.
Banks should consider investing in highly skilled (PhD’s) and subject matter experts to perform independent validations. Additionally, Federal Reserve is looking at Internal Audit function of the bank to conduct independent review of the model development and validation process. This makes Audit exercise more than reconciling balances. They have to analyze and understand whether the models (Retail, PPNR, Market risk, Credit Risk etc) are appropriately developed and conceptually sound and have and both validators and developers have included in their documentation 9 quarter out of sample model performance. Finally audit has to provide its assessment on these items for Fed’s examination.
Supervisors are going to rely on the Audit assessment of the model risk management process hence banks should invest sufficient resources and work towards meeting the regulatory requirements of SR 11 -7 that are applicable to model risk management.
Capital Policy: A BHC’s capital policy should be a distinct, comprehensive written document that addresses the major components of the BHC’s capital planning processes and links to and is supported by other policies. The policy should provide details on how the board and senior management manage, monitor, and make decisions regarding all aspects of capital planning and lay out expectations for the information included in the BHC’s capital plan.
Some banks capital policies provided insufficient detail particularly as it pertained to the decision making process around the level and composition of capital distributions.
Many BHCs’ capital policies lacked a comprehensive suite of payout ratio targets or limits; an explanation for how the BHC arrived at those targets or limits; and, where they did exist, lacked defined response actions to be taken in case of breaches of dividend and/or repurchase payout targets or limits. Capital policies should also include limits on capital distributions and guidelines regarding the analysis Covered BHCs must complete to support their capital actions.
Banks should detail how the management and board manages, monitors and makes decisions regarding capital planning.
Overall Banks should consider bringing together both qualitative and quantitative aspects of the capital policy and present it in its report to the supervisor.
Presentation of Consolidated Pro Forma Results: BHCs should ensure that they have sound processes for review, challenge, and aggregation of estimates used in their capital planning processes. This includes the following
1) An effective internal review of processes used at both the line of business/sub-aggregated and enterprise level, with final review and sign off completed by an informed party not directly involved in those processes.
2) Policies and procedures documenting the process from end to end including the challenge, review process at each stage of the process
3) Set processes for aggregating and finalizing results, including appropriate review and oversight of aggregate results to ensure coherence and consistency of projected outcomes sourced from various forecast providers
4) Most importantly clear documentation of all model overlays, assumptions, limitations and corresponding signoffs by the stakeholders
5) Evidence of oversight and challenge to both processes and outcomes at the appropriate level of management, including documentation of actions taken as a result of questions, issues, or requests that came up during such review and discussions.
Supervisors are very clear in their expectations and Banks should strive to meet these regulatory requirements.
RWA Methodologies: Many BHCs faced challenges with their methodologies for projecting RWAs. Given that the as-of-date RWA calculated for regulatory reporting serves as the foundation for RWA projections in scenario analysis, BHC management should ensure, and provide evidence of, an independent review of RWA regulatory reporting by either internal audit or another control function
Supervisors are looking for independent review of the RWA processes and require associated audits to be up to date.
Banks should provide overall support and documentation for RWA methodologies with respect to underlying assumptions.
AFS fair Value OCI
Under U.S. Generally Accepted Accounting Principles (GAAP), changes in the fair value of AFS securities are reflected in changes in accumulated other comprehensive income (AOCI);
In accordance with the revised capital framework, BHCs with total consolidated assets of $250 billion or more or on balance sheet foreign exposures of $10 billion or more (advanced approaches BHCs) must reflect AOCI items in their regulatory capital beginning in the second quarter of the planning horizon (the first quarter of 2014). Under the transition provisions of the revised capital framework, regulatory capital for advanced approaches BHCs must include 20 percent of eligible AOCI in 2014, 40 percent in 2015, and 60 percent in 2016.
This guidance applies only to advanced approaches BHCs; it does not apply to BHCs with total consolidated assets of $50 billion or more that are not advanced approaches BHCs
Advanced approaches BHCs are expected to evaluate all AFS (and impaired HTM) securities for changes in unrealized gains and losses that flow through OCI under stress scenarios. Stressing fair value is expected to reflect movements in projected spreads, interest rates, foreign exchange rates, and any other relevant factors specific to each asset class. Historical spread and price data may be sourced externally or internally; however, information utilized should be representative of the BHC’s portfolio at a sufficiently granular level to capture the inherent risks of the assets. Additionally, the data utilized for projection is expected to span a sufficient period of time that includes a period of vulnerability for that asset class.
In general structured products include ABS (asset Backed securities) MBS (mortgage backed securities) and other products. Banks have been applying credit spreads to sensitivity of the product and estimating the OCI (other comprehensive income). Supervisors require banks to consider using cash flow based models in lieu of sensitivity based forecasting for structured products.
Final Thought
Banks need to look at their current practices in the lens of above themes and expectations from the supervisor to be able to succeed in their annual stress testing exercise.
At minimum banks need to consider these themes and reflect on their CCAR programs by increasing the business engagement, meeting the guideline laid out for model risk management and finally by leveraging on seamless technology, data and Risk infrastructure.
CCAR stress testing process is performed annually by various banks supervised by Federal Reserve to ensure banks are sufficiently capitalized. In this process banks not only need to ensure they have enough capital to absorb losses in normal times but also during stressed scenarios that include deep recession. Additionally Fed has mandated banks to provide evidence for strong compliance in the area of internal controls around risk identification, measurement and reporting, Model risk management and governance.
WSJ quotes,
“While Deutsche Bank Trust Corp. is expected to be found adequately capitalized by the Fed but will likely receive a warning on qualitative shortcomings, according to people familiar with the matter.
“Deutsche Bank Trust Corporation, which represents less than 5% of Deutsche Bank AG’s total assets, was pleased to participate” in the stress tests this year, a spokeswoman said, adding the bank “will know our results after the Federal Reserve’s announcements.”
Deutsche Bank is currently in a remediation process with the Fed over flaws in areas ranging from its regulatory reporting, risk control, monitoring and compliance systems, these people added. The bank has also been reprimanded by the Fed for flaws in its regulatory reporting, The Wall Street Journal reported last year. In a letter to Deutsche Bank executives in December, a senior official with the Federal Reserve Bank of New York said reports produced by some of the bank’s U.S. arms “are of low quality, inaccurate and unreliable. The size and breadth of errors strongly suggest that the firm’s entire U.S. regulatory reporting structure requires wide-ranging remedial action.”
At the time of the report, a Deutsche Bank spokesman said the German bank has “been working diligently to further strengthen our systems and controls and are committed to being best in class” and said the bank is spending €1 billion ($1.35 billion) globally and appointing about 500 compliance, risk and technology employees in the U.S.
A person familiar with the matter said Santander is also likely to fail for qualitative reasons, rather than because the stress test depleted its capital below regulatory minimums”
To help banks understand Supervisory expectations Federal Reserve has published best practices guide around stress testing process including internal control along with its expectations in August 2013. Additionally, In the CCAR 2015 Instructions include an appendix that summarizes common themes identified by supervisors during the 2014 CCAR cycle with respect to the qualitative element of the capital plan review.
What we are witnessing now is above mentioned two banks have significantly invested resources towards the compliance of CCAR stress testing and found to be capitalized from a quantitative perspective. Fed is coming back after its rigorous examination that the quality of internal controls and some risk measurement aspect of credit portfolios put in place for the stress testing process are not sufficient. Additionally, Federal reserve has been providing their assessment for bank stress testing plan, process and internal controls and issuing MRA (Matter Require Attention) and MRIA ( Matter Immediately require attention) to various banks to fix the problems. In response banks have been rectifying and fixing these problems.
The following eight themes came out of the CCAR 2014 program and are described further below:
(1) sensitivity analysis, (2) assumptions management, (3) model overlays, (4) model risk management,(5) capital policy, (6) presentation of consolidated pro forma financial results, (7) RWA projection methodologies, (8) AFS Fair Value OCI.
These common themes provide additional insight to the specific observations and trends, both positive and negative, which the Federal Reserve noted from its CCAR 2014 review.
Sensitivity Analysis: During CCAR stress testing process, variety of quantitative models are utilized to generate loss estimates for Trading book (Cash and derivative products), Banking book ( Credit portfolio) and other positions on the balance sheet along with Revenue model projections in various scenarios. Each of these models are developed with various assumptions and take variety of inputs ( SPX volatility, Inflation rate etc) to produce proforma estimates. Therefore it is imperative to have understanding of sensitivity of the projections to input variables and various assumptions that form the basis of the forecasting process.
Federal Reserve has noted at most banks sensitivity analysis is not conducted during the model development. Model validation function is stepping in to conduct sensitivity analysis. They are expecting banks to include in sensitivity analysis at minimum projected market share, size of the mortgage market, cost and flow of deposits, utilization rate of credit lines, discount rates, or level and composition of trading assets. However, this list is not exhaustive and conducting sensitivity testing only on these assumptions will not be sufficient to meet supervisors’ expectations in this area. If vendor models are included then sensitivity analysis becomes most important as in most cases the software code is not included.
Banks can clearly meet this requirement by including Sensitivity analysis with in their model risk management policy and make model developers to comply accordingly. Internal Audit (Model reviewers) and Model validation teams should work towards enforcing this as part of broader model risk management requirement.
Assumptions Management: Federal Reserve noted BHCs are expected to clearly document key assumptions used to estimate losses, revenues, expenses, asset and liability balances, and RWA. Documentation should provide the rationale and any empirical support for assumptions and specifically address how they are consistent with scenario conditions. Assumptions should generally be conservative, particularly in areas of high uncertainty, and should be well supported and subject to close oversight and scrutiny.
At most banks we see very clearly loss estimation methodologies and techniques are reasonably in good shape. Federal Reserve is looking for improvising the modelling approaches of the Pre Provision Net Revenues (PPNR) as they are required in the projection of capital. PPNR models utilize an array of modelling techniques including linear regression approach with assumptions around the growth of balances, deposit pricing and spreads for various products.
Banks need to establish a strong engagement of the Business and model developers to understand the dynamics the portfolio balances under various scenario conditions and Assumptions.
Model Overlays: As noted, most BHCs use some form of expert judgment— often as a management adjustment overlay to modeled outputs. In developing management overlays, BHCs should ensure that they have a transparent and repeatable process; that assumptions are clearly outlined and consistent with assumed scenario conditions; and that results are provided with and without adjustments.
Some of the banks are incorporating overlays when the quantitative models are not capturing the underlying dynamics. Often these overlays are not tied to any particular model weakness but used a general “catch-all” adjustment to influence aggregate modeled losses in the interest of conservatism.
Fed wants Banks to incorporate the impact of all risk exposures into their projections of net income over the nine-quarter planning horizon rather than trying to address certain risks and model limitations by adding buffers on top of internally defined capital goals and targets.
Most important if banks are going to have management overlays then they should have an independently Validation process to validate them. This is a must and can’t avoid this lest you will get slapped by the FED with an MRA or MRIA.
Banks can establish clear communication channels with Finance, Business and Risk and conduct the model overlay process in a transparent fashion.
Model Risk Management: Bank’s should ensure that they have sound model risk management, including independent review and validation of all models used in internal capital planning, consistent with existing supervisory guidance on model risk management (SR letter 11-7).
Fed has noted Banks have made significant progress with respect to model risk management. Most of the banks have created model risk management policy and framework to govern the development of the models and their independent validation and review. Despite having this framework and guidance modelling practices at some of the banks is not to supervisory expectations. Federal Reserve has highlighted that Banks need to improvise their practices with in the areas of Conceptual soundness and Model performance testing.
Banks have to not just create model risk management framework but also should enforce it. This will result in a strategic business if implemented correctly. Stress testing exercise is a deep dive into portfolio performance under variety of scenarios using the underlying models. Hence stress test will become litmus test for the conceptual soundness of the model along with associated outcome analysis.
Banks should consider investing in highly skilled (PhD’s) and subject matter experts to perform independent validations. Additionally, Federal Reserve is looking at Internal Audit function of the bank to conduct independent review of the model development and validation process. This makes Audit exercise more than reconciling balances. They have to analyze and understand whether the models (Retail, PPNR, Market risk, Credit Risk etc) are appropriately developed and conceptually sound and have and both validators and developers have included in their documentation 9 quarter out of sample model performance. Finally audit has to provide its assessment on these items for Fed’s examination.
Supervisors are going to rely on the Audit assessment of the model risk management process hence banks should invest sufficient resources and work towards meeting the regulatory requirements of SR 11 -7 that are applicable to model risk management.
Capital Policy: A BHC’s capital policy should be a distinct, comprehensive written document that addresses the major components of the BHC’s capital planning processes and links to and is supported by other policies. The policy should provide details on how the board and senior management manage, monitor, and make decisions regarding all aspects of capital planning and lay out expectations for the information included in the BHC’s capital plan.
Some banks capital policies provided insufficient detail particularly as it pertained to the decision making process around the level and composition of capital distributions.
Many BHCs’ capital policies lacked a comprehensive suite of payout ratio targets or limits; an explanation for how the BHC arrived at those targets or limits; and, where they did exist, lacked defined response actions to be taken in case of breaches of dividend and/or repurchase payout targets or limits. Capital policies should also include limits on capital distributions and guidelines regarding the analysis Covered BHCs must complete to support their capital actions.
Banks should detail how the management and board manages, monitors and makes decisions regarding capital planning.
Overall Banks should consider bringing together both qualitative and quantitative aspects of the capital policy and present it in its report to the supervisor.
Presentation of Consolidated Pro Forma Results: BHCs should ensure that they have sound processes for review, challenge, and aggregation of estimates used in their capital planning processes. This includes the following
1) An effective internal review of processes used at both the line of business/sub-aggregated and enterprise level, with final review and sign off completed by an informed party not directly involved in those processes.
2) Policies and procedures documenting the process from end to end including the challenge, review process at each stage of the process
3) Set processes for aggregating and finalizing results, including appropriate review and oversight of aggregate results to ensure coherence and consistency of projected outcomes sourced from various forecast providers
4) Most importantly clear documentation of all model overlays, assumptions, limitations and corresponding signoffs by the stakeholders
5) Evidence of oversight and challenge to both processes and outcomes at the appropriate level of management, including documentation of actions taken as a result of questions, issues, or requests that came up during such review and discussions.
Supervisors are very clear in their expectations and Banks should strive to meet these regulatory requirements.
RWA Methodologies: Many BHCs faced challenges with their methodologies for projecting RWAs. Given that the as-of-date RWA calculated for regulatory reporting serves as the foundation for RWA projections in scenario analysis, BHC management should ensure, and provide evidence of, an independent review of RWA regulatory reporting by either internal audit or another control function
Supervisors are looking for independent review of the RWA processes and require associated audits to be up to date.
Banks should provide overall support and documentation for RWA methodologies with respect to underlying assumptions.
AFS fair Value OCI
Under U.S. Generally Accepted Accounting Principles (GAAP), changes in the fair value of AFS securities are reflected in changes in accumulated other comprehensive income (AOCI);
In accordance with the revised capital framework, BHCs with total consolidated assets of $250 billion or more or on balance sheet foreign exposures of $10 billion or more (advanced approaches BHCs) must reflect AOCI items in their regulatory capital beginning in the second quarter of the planning horizon (the first quarter of 2014). Under the transition provisions of the revised capital framework, regulatory capital for advanced approaches BHCs must include 20 percent of eligible AOCI in 2014, 40 percent in 2015, and 60 percent in 2016.
This guidance applies only to advanced approaches BHCs; it does not apply to BHCs with total consolidated assets of $50 billion or more that are not advanced approaches BHCs
Advanced approaches BHCs are expected to evaluate all AFS (and impaired HTM) securities for changes in unrealized gains and losses that flow through OCI under stress scenarios. Stressing fair value is expected to reflect movements in projected spreads, interest rates, foreign exchange rates, and any other relevant factors specific to each asset class. Historical spread and price data may be sourced externally or internally; however, information utilized should be representative of the BHC’s portfolio at a sufficiently granular level to capture the inherent risks of the assets. Additionally, the data utilized for projection is expected to span a sufficient period of time that includes a period of vulnerability for that asset class.
In general structured products include ABS (asset Backed securities) MBS (mortgage backed securities) and other products. Banks have been applying credit spreads to sensitivity of the product and estimating the OCI (other comprehensive income). Supervisors require banks to consider using cash flow based models in lieu of sensitivity based forecasting for structured products.
Final Thought
Banks need to look at their current practices in the lens of above themes and expectations from the supervisor to be able to succeed in their annual stress testing exercise.
At minimum banks need to consider these themes and reflect on their CCAR programs by increasing the business engagement, meeting the guideline laid out for model risk management and finally by leveraging on seamless technology, data and Risk infrastructure.
