If you work in financial services, and are paying attention to the reform agenda, it is a safe bet you are uncomfortably aware of the emerging stress-testing and capital planning requirements promulgated by bank supervisory agencies globally.
"Uncomfortable" because you realize the enormity of the challenge of the new requirements. "Aware" because these semiannual (or annual, depending on average balance sheet size) exercises are taking up an enormous amount of your time, energy and resources – at the professional staff, senior executive, and board level. In a bid to improve transparency and increase confidence that, indeed, bank balance sheets are not black boxes, global policy leaders have embarked on an ambitious agenda that has as its centerpiece improved stress-testing, capital planning, and risk appetite frameworks. In the United States, this is known as the Comprehensive Capital Assessment and Review and the Capital Plan Review.
Recent results from the 2013 CCAR and CapPR, released this month, underscore the importance of the stress-testing and capital planning exercise, and the need to have strong internal analytical and risk governance processes in support of efficient and accurate submissions. Although the exercise is quantitatively and organizationally difficult, having the systems and controls that permit an accurate analysis can improve transparency and reduce the risks of black-box banking.
Some have opined, in these pages, that these tests are a senseless compliance exercise and, as structured, inconsistent with enhancing safety and soundness and reducing systemic risk. This is simply untrue. However, for those banks that approach these new requirements with this perspective, it is likely a self-fulfilling prediction that the new requirements will be treated as an agonizing and low-value regulatory compliance exercise.
Unfortunately, this mistaken view may persist until a bank's primary regulator steps in and prohibits a dividend payment, stock repurchase program, merger, acquisition, or incentive compensation plan, and issues a "matter requiring board attention" notice or – worse – a cease-and-desist order or capital directive. Such banks may make relatively attractive acquisition targets for firms that are taking the longer view.
Other banks understand how the new requirements can retool and dramatically enhance credit loss estimation, budgeting and planning, and asset-liability management processes. These are risk and finance processes that in many banks are difficult to coordinate, harmonize, and validate in a "straight-through" and consistent fashion.
With validation of forward-looking and scenario-based forecasts an increasingly recognized sign of organizational and managerial strength, most banks are taking the new requirements seriously and reimagining and re-inventing their processes and risk analytics. To be sure, the complexity of the new stress-testing and capital planning requirements is daunting and requires a commitment at senior leadership levels and strong architecture. However, done correctly the promised utility of these tests - for planning, analysis, and decision-making - is nontrivial.
Firms that are taking an organized and strategic approach to the new mandates may remember the Federal Deposit Insurance Corp. Improvement Act's Section 305 requirements. This provision in the 1991 law proposed to mandate capital charges for exposure to interest rate risk. Although this proposal ultimately was watered down, due in part to international Basel convergence issues and cross-border competitiveness concerns, it launched a Renaissance in balance sheet management and forward-looking simulations for the balance sheet and income statement.
Modeling a balance sheet and income statement under adverse scenarios is a tried and true concept. In fact, the Section 305 requirements were a primary reason for making the Camel bank rating system (capital, asset quality, management, earnings, and liability management) a plural – Camels, with "s" standing for the sensitivity of a bank's earnings and economic value to interest rate changes. Today, ALM models are an integral part of all asset-liability management committees' monthly processes, and these dynamic projections of interest rate risk exposure are disclosed as part of annual SEC-required reporting. Will the same occur for stress-testing and CCAR processes?
