Stress testing gives regulators a view of capital planning
Risk research and quantitative solutions
In one of our earlier articles for risk insights (see Venture capital and lessons from Titanic), we explain financial (or venture capital) compared to regulatory capital (RegCap) and available capital or capital available. In this article, we plan to take a deeper look into the relationship between stress testing, RegCap and E-Cap.
Economic capital (E-Cap), an internal measure derived from the firm’s risk appetite, is the amount of additional equity required to limit the likelihood of financial distress to a level deemed acceptable by senior management. It differs from regulatory capital in that RegCap is an external measure required by law and has nothing to do with the senior manager’s opinion about the amount required by the company’s risk appetite.
Despite appropriate levels of E-Cap (which was at least equal to levels of RegCap), there were still enormous financial sector failures during the 2007-2009 financial crisis. E-Cap or, more specifically, management’s perception of health during a hypothetical event as an unlikely major economic downturn did not adequately predict the level of capital needed to cover serious losses experienced during the crisis. As we now know, many banks experienced losses greater than they assumed.
Regulators still require maintaining E-Cap levels. As pointed out in the “Titanic” article, despite its limitations, E-Cap still gives us the best and broadest view of risk. It’s just the lack of transparency in the E-Cap determination process that gives regulators heartburn.
In addition to management’s view, regulators now want banks to determine capital levels under three hypothetical events or scenarios:
Baseline – average forecasts from studies of economic forecasters.
negative – moderate US recession defined as a 1% decline in US real GDP and an unemployment rate of 9.25 percent.
Seriously negative – severe US recession with unemployment, peaking at 11.25 percent.
Go into stress testing and stress scenario capital calculations
There are two stress testing regimens today: Dodd-Frank Act Stress Tests (DFAST) and Comprehensive capital analysis and review (CCSR).
- DFAST applies to banks with more than DKK 10 billion. Dollars in assets and contains a standardized set of capital assumptions. Under DFAST, the Federal Reserve projects each bank’s balance sheet, net income and resulting levels of capital by stress, regulatory capital ratio and a Tier 1 common risk-based capital ratio under the three scenarios described above.
- CCAR applies to 31 banks – banks with assets in excess of $ 50 billion (exceptions are GE Capital, TD Bank US Holdings, Charles Schwab and BancWest Corp.) – and uses each bank management’s planned capital transactions. Here, the Federal Reserve evaluates qualitatively and quantitatively each bank’s plans to distribute dividends and share repurchases.
Stress tests do not produce a fourth type of capital (in addition to E-Cap, RegCap and working capital). Rather, calculated capital through the new stress testing regimes is regulatory capital. Now the regulators have a view of capital planning where they had not before.
Stress tests are here to stay; it is the new normal. But you’re not alone – all banks are in the same boat. Check this out benchmarking tool. It will compare your responses with responses from 100 senior risks and finance executives from European and US banks to help you measure your stress test maturity. And read the supplementary research report, Stressed out? How US and European banks respond to regulatory stress tests.