How this year’s stress tests will shake out

WASHINGTON — The Federal Reserve is preparing to release the results of its annual stress tests of the largest U.S. banks in the coming weeks in what is likely to be the last iteration of the post-crisis supervisory program before sweeping changes are made.

The central bank is slated to announce the results of the 2017 Dodd-Frank Act Stress Tests on Thursday and the results of the more involved Comprehensive Capital Analysis and Review stress tests on June 28.

The Dodd-Frank, or DFAST, results are somewhat less consequential than CCAR in that there is no real impact for a bank whose capital levels fall below the minimum requirements in DFAST. Banks whose capital levels fall below the minimums in CCAR, however, can be barred from paying dividends until they meet the minimum requirements.

Nine banks that have fallen short on the Fed's stress tests

Yet while banks have been cited for qualitative shortcomings recently, no bank has failed the quantitative test since Zions’ capital plan was rejected in 2014, though objections were somewhat more common in the first few years since the program was put in place.

Michael Alix, principal and Financial Services Risk Advisory Leader at PricewaterhouseCoopers, said part of that effect is because the Fed instituted a rule several year ago that allow them to make adjustments to their capital plan if they fail on their first attempt — essentially giving them a mulligan. But banks are also simply better capitalized and conditioned to withstand the kinds of economic stresses that the Fed lays out in its hypothetical scenarios.

“That stress creates assumptions that are not severe enough to fail any institution quantitatively,” Alix said. “The firms have built their capital, and it’s actually accomplishing the objective of demonstrating — at least with respect to the stress they conjured up — that firms are sufficiently resilient. That’s why you’re not seeing failures.”

Chris Whalen, chairman of Whalen Global Advisors LLC, said the stress testing exercise has always been something of a cat-and-mouse game between the banks and the Fed, and the banks have gotten better in recent years at allocating their capital in such a way as to pass the tests while still keeping as much of their capital activated as possible.

“They didn’t get a lot of interactive feedback from the board, so over time they have tried to at least figure out the pieces that they can figure out,” Whalen said. “That’s kind of the game that we play … the point of the exercise is how much capital can be returned to the street.”

DFAST and CCAR are similar, but there are important differences. Both take a bank’s balance sheet and run the portfolios through nine consecutive future quarters under three hypothetical economic scenarios: baseline, adverse, and severely adverse. The severely adverse scenario is meant to be roughly as severe as the 2008 financial crisis, though the particulars of each scenario vary from year to year.

DFAST examines each bank’s performance using prescribed assumptions about the bank’s capital plan, thus allowing regulators to make results more comparable from bank to bank. CCAR, however, uses the bank’s own capital plan, thus creating a more realistic estimate of how the bank’s capital levels would perform. While DFAST is mandated by law, CCAR was developed after the crisis via rulemaking based on the Fed’s existing supervisory authority.

CCAR contains both qualitative and quantitative examinations, though this year marks the first that the Fed has scaled back its qualitative examinations. The agency passed a rule in January that would limit the qualitative test to only banks with more than $250 billion in total assets, more than $75 billion in nonbank assets and are designated a global systemically important bank. The effect of that rule is that only 13 of the 34 banks subject to CCAR will undergo a qualitative assessment this year.

Whalen said the qualitative test tends to haunt those banks that have had trouble passing it in the past. The purpose of the test, he said, is for the Fed to have confidence that your internal models actually do a good job of examining a business’ activities, and once a bank’s internal systems are deemed up to snuff, it is easier to maintain that level of quality going forward.

“When you talk about this qualitative stuff, what you’re really talking about is, Does the board think that you have in place a process that lets you connect your model to … your actuals?” Whalen said. “In the past, they have dinged people when they have felt there is not a connection between the two, and they thought the bank was kind of guessing.”

The 2018 stress tests may prove a test of how helpful the Fed’s feedback is and how willing banks are to learn from it. Next year five banks — Barclays, Credit Suisse, UBS, Royal Bank of Canada and Deutsche Bank — will have their U.S.-based International Holding Companies fully participate in the stress tests. Another IHC, BNP Paribas, will participate in the quantitative portion of CCAR in 2018 as well.

Those IHCs are undergoing “dry run” tests this year, but not having the results publicized. (Deutsche Bank Trust Corporation, a subsidiary of Deutsche Bank USA Corp., has already been participating in the stress tests but will be replaced by the parent company.)

Alix said those banks may face a steep learning curve, but that is mostly dependent on whether the Fed gives them constructive feedback this year.

“It all depends on how those institutions respond to the feedback they get this year,” Alix said. “They’ve had a practice run, and they’ve had the Fed closely examining them. How much progress they make will determine how they fare next year.”

The Fed’s stress testing program has been the object of much scrutiny in recent months, with Republicans in Congress calling for wholesale changes and the Treasury Department last week making somewhat more modest suggestions. Fed Gov. Jerome Powell, who heads the Fed’s Supervisory Committee, said the central bank itself is contemplating ways to make the program more transparent and effective.

Whalen said many of the suggestions being contemplated, particularly Powell’s initiative to dial back the supervisory obligations of bank boards, will probably make the stress testing program a less interesting sport for markets to watch in coming years.

“The point of the exercise, going back to Tim Geithner, was to calm everybody down and restore investor confidence,” Whalen said, referring to the former Treasury secretary. “I think over time what the industry is going to say to everybody is, ‘Look we don’t have to have the board involved in this for three months.’ ”

Alix said the program is likely to evolve into less of a spectacle over time and more as a part of ordinary bank supervision, if for no other reason than because there will be less to see. But all of that could change when the economy faces a real stress event, particularly one that no one saw coming.

“With some of those changes being implemented and continued resilience and economic growth … it’s going to be a much more boring process, until there are events in the world and marketplace that really create capital depletion and additional stress," Alix said. "It would need to be big and something that wasn’t anticipated."