Capital Planning and Stress Testing — Regulatory Relief — Not Reprieve

With the enactment of the Economic Growth, Regulatory Relief, and Consumer Protection Act on May 24, 2018, mid-size banks have now received relief from the regulatory burden of filing stress tests with US regulators. However, the relief does not reduce the need to execute stress tests and incorporate into capital planning. Regulators continue to see the importance of strong capital planning processes to minimize bank loans and demonstrate bank soundness and strong bank management. Banks should see an opportunity to leverage the extensive work in capital stress testing to make strategic and risk-based decisions.

Regulators consistently have pointed to pre- and post- Dodd-Frank guidance in discussions about capital planning and stress testing. This guidance includes SR 09-4 (Applying Supervisory Guidance and Regulations on the Payment of Dividends, Stock Redemptions, and Stock Repurchases at Bank Holding Companies), and SR 12-7 (Supervisory Guidance on Stress Testing for Banking Organizations with More Than $10 Billion in Total Consolidated Assets).

Mid-size banks should consider four areas where they can take advantage of the regulatory relief but also benefit from their capital planning investment:

  • Timing of executing stress tests
  • Scenario selection
  • Frequency
  • Modeling choices

Timing of Executing Stress Tests

With its enactment, banks will no longer be required to file the stress tests on July 31 each year. They can now conduct stress tests when it makes sense to do so and align with existing processes such as budget season or strategic planning time. Many institutions find that updating the capital plan, or at least conducting a review, on a semiannual basis has become a standard and useful practice. This has several positive outcomes:

  • Use of stress test results can be better demonstrated — which is the goal of the supervisors in any event
  • The forecast periods of the disparate exercises will align and differences between base and stress can be better understood and discussed
  • Resources can be better leveraged across the organization 
  • Stress tests are more likely to be used to assess operations “beyond regulation”

Scenario Selection

Many banks have articulated that the national scenarios used in Dodd-Frank Act Stress Test (DFAST) do not depict the idiosyncrasies of their regional footprints — thus making the results less meaningful. The change in the requirements allows banks to develop their own scenarios based on their footprints and risk profiles.

In doing this, banks will want to demonstrate how the scenarios have been constructed and aligned with the risk profile of the bank. Banks will also want to demonstrate varying levels of stress to show how the bank’s performance, including capital and liquidity levels, may be impacted under a series of scenarios.

This scenario analysis will allow banks to make informed capital decisions based on a variety of hypothetical paths.

Frequency

While an annual exercise may make sense for some banks, others may find running stress tests more frequently allows them a greater understanding of how their portfolios change and behave. However, more frequent stress tests have been a challenge since banks have had to use “down-time” between stress tests to address supervisory findings and redevelop models. Given the change in the rules, there will likely be a reduction in supervisory findings; and therefore, more time to conduct meaningful stress tests throughout the year.

By conducting more frequent stress tests and less regulatory-focused, organizations can focus on strategic decision making across the enterprise, and not just within capital and liquidity planning. Additionally, as banks’ main concern will no longer be meeting regulatory requirements, they will be able to assess correlations between different risk types and produce actionable results. 

Modeling Choices

In the past, developing models for supervisory stress tests, banks may have made modeling choices based solely on supervisory preference or feedback leading to models that bank management may not have “believed” in. In considering the models to be used for capital planning and stress testing, banks should consider what models make sense for their businesses and portfolios – and what types of models will best reflect performance under stress conditions. Banks should also consider what models are necessary. For example, credit models for immaterial portfolios may not be necessary if the bank can develop a reasonable management judgment approach.

Banks should also consider the frequency of model updates, model redevelopment, and model validation. Appropriate models likely do not need to be rebuilt every year as long as the bank is monitoring the model for performance and considering any deterioration in the performance in buffers to capital requirements. In addition, model validation may be necessary on a less frequent basis given the reduced risk level of the model and less frequent changes to the models themselves. Banks should ensure their model risk governance framework considers these changes.

One thing is for sure, banks should not look upon the regulatory relief as a full reprieve — they should see this as opportunity to get value out of the investment they have made thus far. Banks should take the respite and make thoughtful choices on how to use the frameworks they’ve developed to make meaningful business decisions, including portfolio mix changes, mergers and acquisitions, and new customer targets.  

Regulators will expect banks to demonstrate a strong understanding of their risk profiles in the development and use of capital planning and stress testing frameworks. Banks that use industry models to simply check the box will garner supervisory attention that may impede regulatory approvals.  

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