There's more than meets the eye for the banking community at large in the results of the most recent stress tests applied to 19 of the largest U.S. financial companies.
The immediate take away is that the exercise has served its purpose – namely, to provide a measure of confidence to the marketplace regarding the general financial health of these banks, and to permit those having achieved passing grades to implement or increase cash dividends as well as to utilize capital for repurchase of common stock.
However, the implications of the report go much deeper and are much broader than that. My view is that it heralds a whole new way of life for the nation’s banks.
The opening remark of the Fed’s report underscores the regulator’s primary objective: "The Comprehensive Capital Analysis and Review … is a supervisory assessment by the Federal Reserve of the capital planning processes and capital adequacy of these large, complex bank holding companies." (Emphasis added.)
This statement, as well as others throughout the CCAR report, has far-reaching implications for US banks of all sizes, and eventually the regulation of the global banking market. Specifically:
1. Capital Planning Process – The report raises the stress testing process to a level that makes clear that both executive management and boards of banks will be required to assume greater responsibility for capital planning. Management and directors will need to understand the capital planning and stress testing process, as well as its implication on strategic decision-making. They will also have to take a more active and responsible role in the process than heretofore was required of them.
2. Stress Testing Frequency – The report emphasizes that stress testing is an ongoing process, and not an occasional exercise, and that it is integral to all strategic bank planning initiatives and capital activities. Annual or semiannual stress tests might meet the requirements of the Dodd-Frank Act functionally, but banks have now been forewarned that stress testing will be an ongoing process. Banking officials need to be continually prepared to demonstrate their institution’s capital adequacy. State, FDIC and Federal Reserve officials have been giving this message to Community Banks for the last year.
3. Expanded Regulation – The Fed also makes it clear that any major capital event and/or significant market change to a bank will be subject to regulatory re-evaluation.
4. Size Doesn't Matter – Importantly, these requirements are not just limited to the 19 largest banks considered in the report. Banks with consolidated assets of $10 billion or less have been put on notice as well that the new requirements, though of slightly more limited scope, will be applied to them, through the Capital Planning Review.
In commenting on CapPR, the Fed says it recognizes that most "firms have not been through such a coordinated exercise before and that time might be needed to build and implement their internal systems necessary to satisfy the rigorous data collection requirements needed for a separate supervisory stress test."
What clearly is being mandated is a more rigorous and ongoing stress testing process than that covered under Dodd-Frank, and its integration into bank strategic planning. Having a stress-tested strategic planning process is becoming best practice.
More work remains to be done in order for the Fed's approach to achieve universal applicability. What it comes down to is that capital adequacy is a measure of sustainability, not necessarily efficiency and profitability. The banking industry, its managements and directors, have been served notice that much more will be required of them, including shouldering a bigger share of responsibility for the maintenance of a healthy and sound capital structure and the increasing challenge of maximizing profitability within the regulatory capital adequacy constraints.
Kamal Mustafa is the CEO of Invictus Consulting Group. This piece is adapted from a letter sent to the firm’s clients.