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.

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.

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.

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.

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

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.