WASHINGTON Banks with assets totaling between $10 billion and $50 billion have begun publishing the results of their Dodd-Frank Act mandated stress tests this week and will continue to do so through the end of the month, providing a new window into the workings of regional institutions.
But the tests and the processes for publishing their results differ substantially from the Comprehensive Capital Analysis and Review stress test that the largest banks have been undergoing for years.
Below is a series of frequently asked questions on the tests and what the results mean for the industry:
Since when have midsize banks had to do stress tests?
The Dodd-Frank Act mandates that banks with at least $10 billion of assets undergo stress testing, though financial regulators have used their discretion to limit the more intensive CCAR process to banks with at least $50 billion. Banks with between $10 billion and $50 billion in assets started taking the Dodd-Frank Act Stress Tests last year, but this is the first year that the results have been published.
How many banks are we talking about here?
Different subsidiaries have to report to different regulators, like the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp., but the most accurate count of total entities would be the number of bank holding companies reporting to the Federal Reserve Board. There are 42 such firms with assets between $10 billion and $50 billion in the U.S.
How are these tests different from the CCAR?
Under Dodd-Frank, the largest banks submit vast quantities of data about their businesses directly to the Fed for analysis. The Fed examines the banks' balance sheets under three hypothetical scenarios of varying conditions and severity, using a common capital plan. CCAR, by contrast, runs tests under the same scenarios using the banks' own capital management plan, creating a more realistic set of results for how the banks would perform.
But the Dodd-Frank rules for midsize banks are quite different, and midsize banks are exempt from CCAR. The midsize DFAST test is developed and run by the individual banks themselves, making the results fairly idiosyncratic so much so that the Fed itself said in a June 2 press release that the midsize results "are hypothetical results and are not intended to be forecasts or expected outcomes." That said, both the midsize and large stress tests use the same hypothetical economic scenarios put out by the Fed and examine the banks' balance sheet performance under those scenarios.
So do they provide any useful information?
The tests do provide insight into the risks facing midsize banks. They have to include a description of the risks that were examined in the test, a description of the bank's methodology in developing its test, and the results of the test. The results specifically must include the estimates of losses, revenues, net income, post-stress capital ratios, and some details to explain "the most significant causes for the changes in regulatory capital ratios."
How many banks will fail the stress test?
None. Unlike CCAR (but like DFAST for large banks) there are no minimum stress capital thresholds for the banks to fall under, and therefore there is no regulatory penalty for a midsize bank's performance in the tests. The Fed also does not approve the banks' stress test models before they run the test, so not only can a bank not fail the test, their models are not subject to approval beyond the minimum reporting requirements outlined above.
That sounds pretty weak.
Compared to CCAR, it is. Yet that is intentional. Regulators in general and the Fed in particular have been very keen on "tailoring" their regulations to fit the risk profile of variously sized institutions, and as a result, the midsize Dodd-Frank stress tests are not only far less onerous than their large bank counterparts in terms of compliance burden, but also less valuable in terms of the deep insights that can be gleaned from the results.
That isn't to say that banks are necessarily happy with the tests. Hugh Carney, senior regulatory counsel at the American Bankers Association, said that they would prefer that the tests' results not be disclosed at all, simply because the idiosyncratic nature of the tests makes for a greater potential for the results to be misinterpreted.
"One of the difficulties these banks have had in dealing with these requirements is that the banking agencies issue national macroeconomic scenarios which may not be the best test for a smaller bank with a limited geographic footprint or a limited business model that focuses in on a particular type of asset," Carney said. "It creates a situation where comparing the results would be unwise, I think."
So what's the point of doing this?
That depends on who you ask. Carney said that Dodd-Frank required banks to do something, and so this is a less- intrusive way of meeting that requirement. Some of the legislative proposals that ABA has supported would raise the stress testing minimum threshold, which Carney said would obviate the need for the midsize tests.
Dennis Kelleher, president of public advocacy group Better Markets, said that even though the tests do not reveal the same extensive, comparable results that we get each year on the big banks from CCAR, the midsize DFAST test is still useful. The results will give regulators insight into whether banks are diversified enough or stable enough to withstand certain events, and the banks themselves will have a more systematized process for learning how their balance sheets hold up under stress, he said.
"They're not going to have the same robust comparative analysis that you do with the big banks, but they're still going to be very valuable not just to regulators but to bank boards and bank executives," Kelleher said. "It's going to make them think about the future in a much more concrete and particular way than they would otherwise."
It is also worth noting that just because banks are relatively small does not mean they have no potential for systemic risk. The savings and loan crisis of the 1980s involved scores of small, relatively innocuous financial institutions that collectively created a major financial crisis, so stress testing of this kind could potentially be useful to uncover broad trends like that as well.
How else might these midsize bank stress tests be used, or how might they be used in the future?
There are some indications that midsized banks are looking to these tests as part of their mergers and acquisition activity.
Anna Krayn, head of stress testing for Moody's Analytics, said that the firm conducted a survey of midsized banks earlier this year that suggested that the test results gave banks an insight into their strengths and weaknesses, and allowed them to see whether they are well poised to acquire or merge with a bank of a certain profile.
This is in part because the size of the banks in question is in a band of asset size that is highly susceptible to combination smaller community banks are unlikely to be aggressively merging, whereas larger banks are already large, diverse and complex. But Krayn said regulators are also routinely asking newly-combined banks to conduct stress testing in order to evaluate the viability of the merger.
"Today if you were looking at an acquisition, the regulators would ask you to consider stress testing as part of your post-merger analysis," Krayn said.
Are these tests going to get stronger and more refined over time as with CCAR, or are they going to stay more or less as they are?
The expectation is that they will not get appreciably stronger over time, at least not at the behest of regulators. Carney said that when the banks began running the tests for the first time last year, there was a "significant amount of variability" between banks in the sophistication of their internal stress testing models. But that variability was often reflected in the difference between banks' complexity and business models, and he said there is little indication that the Fed intends to make the tests more uniform over time.
Krayn agreed, saying that the concern among regulators appears to be more about whether the stress tests are too harsh given the level of systemic and prudential risk involved.
"The conversation seems to be more around whether this is overly burdensome for midsize banks," Krayn said.