What is Capital Planning & Stress Testing?
Stress testing quantitatively evaluates potential adverse macroeconomic environments. Through accurate stress testing and capital planning, your institution can ensure the integrity in the capital planning process, evaluate credit risk, and confirm risk assessments are based on assumptions related to potential adverse external events. It is essential that you are prepared.
Capital Planning & Stress Testing is a Must
Stress testing offers key insights about your institution’s financial positions that exceed regulatory requirements, making stress tests a must for all depositories. ALM First Analytics’ comprehensive examination of the balance sheet allows you as a leader to critically evaluate your current position and potential for success within various scenarios.
Accurate, detailed stress testing analyses provide:
- Confidence that your institution has adequate capital to survive a market downturn
- Assurance of adequacy of allowance for loan and lease losses
- Identification of possible future problems, such as an over-concentration
- Improved decision-making as management sees the need to set risk-tolerance levels
- Enhanced capital and asset planning by verifying risk-reward assumptions
- Clarification of the institution’s position to the regulators
- A diagnosis of areas needing strategic and operational improvement
The Value of ALM First Analytics
Establishing and executing a capital stress testing process requires time and modeling capacity. You can benefit by partnering with ALM First Analytics – we are experienced in developing an organized approach that helps keep the program moving smoothly.
ALM First Analytics will:
- Run required scenarios: Scenario simulations are critical. As part of stress testing, the Federal Reserve issues scenarios that incorporate a baseline status, as well as those that assume adverse and severely adverse economic environments.
- Implement assumptions about loss and recovery: A cornerstone of capital stress testing is determining the assumption of principal losses and severities. To ensure assumptions are appropriately designed for the balance sheet, delinquency, and charge-off information should be captured across all collateral types. By understanding the depository’s performance in a typical environment, it will be easier to predict results under adverse market conditions.
- Execute analyses: Conducting regression analyses both on performance and on changes in macroeconomic variables will help an institution understand its sensitivity to economic factors. To be most helpful, these analyses should incorporate unique scenarios unrelated to current market performance, as they wouldn’t be included in the model projections.
- Prepare reports: To aid in strategic planning and auditing, testing, and capital planning, ALM First Analytics’ methods are transparent and well-documented for easy auditing. These include highlighting key variables, assumptions, and the institution’s sensitivity to particular changes. For maximum effectiveness, these credit-monitoring reports should be available during planning sessions, liquidity discussions, and profitability analyses.
What economic scenarios do ALM First Analytics run?
ALM First will employ and customize the supervisory scenarios suggested by the Federal Reserve in a baseline, adverse, and severely adverse scenario.
- Baseline Scenario – follows a contour very similar to the average projections from surveys of economic forecasters.
- Adverse Scenario – is characterized by a weakening in economic activity across all of the economies, which includes a sudden rise in domestic inflation that brings about a rapid increase in short- and long-term interest rates. This hypothetical scenario is designed to assess the strength of the banking organizations and their resilience to an unfavorable economic environment.
- Severely Adverse Scenario – is the most severe of the scenarios and is characterized by a substantial weakening in economic activity across all of the economies included in the scenario. In addition, a significant further weakening in the U.S. housing market occurs. This scenario is designed to reflect the economic and financial conditions typical of a severe post-World War II U.S. recession.
Stress testing can be applied in “reverse”, as well, whereby a specific adverse outcome is assumed that is sufficient to breach your institutions capital ratios and is commonly referred to as “break the bank” scenario. The key objective of the reverse stress testing is to overcome disaster myopia and the possibility that a false sense of security might arise from regular stress testing in which institutions identify manageable impacts.
What is the basis for these plan and testing requirements?
Capital stress testing for larger institutions comes out of the “Dodd-Frank Wall Street Reform and Consumer Protection Act,” which resulted in the Dodd-Frank Act Stress Testing (DFAST) regulation. The NCUA requires federally insured credit unions with $10 billion or more in assets to submit capital plans and perform capital stress tests. In concert with Dodd Frank, the Federal Reserve Board created the Comprehensive Capital Analysis and Review (CCAR) rule, which applies to bank-holding companies with assets of $50 billion or more in assets.
What is the Dodd-Frank Act Stress Test (DFAST)?
The Dodd-Frank Act Stress Test (DFAST) is designed to increase financial stability and prevent future devastation from financial crises. Legislation requires DFAST for mid-sized, bank holding companies with consolidated assets between $10 billion and $50 billion. For this forecasting exercise, designed to evaluate the bank holding company’s capital position, the Federal Reserve selects three stress-testing scenarios: a baseline or “expected” situation; a more adverse environment, due to potential economic event; and a severely adverse environment, due to an even larger economic impact.
Examples of these economic events could include a notable drop in the stock market, a hit to GDP growth, a housing recession, or other negative economic factors. The analyses would test the effect on revenue, income, liquidity and capital for a nine-quarter “planning horizon.” The consistency of these test assumptions across the entire subjected industry component allows for valuable comparisons. In addition, the Fed releases results every year, thereby providing transparency to investors.
This legislation is recognized as the most significant legislative change to U.S. financial regulation since the Glass-Steagall Act.
What is the Comprehensive Capital Analysis & Review (CCAR)?
The Comprehensive Capital Analysis & Review (CCAR) applies to bank holding companies with consolidated assets greater than $50 billion, requiring them to submit a proposed capital plan on an annual basis to the Federal Reserve. CCAR is designed to evaluate capital adequacy and current plans for capital distributions.
Why the heavy focus on capital?
Capital represents the portion of a financial institution’s balance sheet that is not legally required to be repaid to anyone. It is a foundation of the balance sheet and must be able to withstand major economic movements. These stress tests evaluate capital strength.
- Capital belongs to the stakeholders: shareholders and members
- Capital is first in line for losses and first in line for profits
- Capital is a type of funding that an institution uses to finance the purchases of assets and the making of loans
- Capital designates the percentage of assets that a financial institution can stand to lose without becoming insolvent
- Strong capital promotes public confidence, both in the institution and in the financial system as a whole
How much capital should my institution hold?
Like with many questions, the answer is “It depends.” The institution needs sufficient capital to protect itself from negative events, to prove its health and long-term viability, and to meet regulatory, rating, and investor-determined requirements.
However, excess capital is a bad idea. It is expensive; it carries more risk for investors than debt securities or deposits; a financial institution holding excess capital must earn higher profits, all else equal, to generate the same return on equity for capital providers; and the government’s deposit guarantee makes excess capital less valuable and transfers risk from the government to the investor.
The best way to determine a proper capital holding requires a solid understanding of your current position, smart planning, and strong analytics.
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All investing is subject to risk, including the possible loss of the money you invest.
“ALM First” is a brand name for a financial services business conducted by ALM First Group, LLC (“ALM First”) through its wholly owned subsidiaries: ALM First Financial Advisors, LLC (“ALM First Financial Advisors”); ALM First Advisors, LLC (“ALM First Advisors”); and ALM First Analytics, LLC (“ALM First Analytics”). Investment advisory services are offered through ALM First Financial Advisors, an SEC registered investment adviser. Balance sheet advisory services are offered through ALM First Advisors. Financial reporting services, loan introduction services, and other special project services are offered through ALM First Analytics. Neither ALM First nor any of its subsidiaries provide legal, tax, or accounting advice.
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