Complying with the DFAST/CCAR requirements within an existing quantitative models and model risk management framework is one of the most daunting of the many recent challenges banks, Bank Holding Companies (BHC) and some Investment Holding Companies (IHC) currently face. The Dodd-Frank Act Stress Tests (DFAST) require all financial institutions with total assets above $10 billion to do stress tests on their portfolio and balance sheet. The Comprehensive Capital Analysis and Review (CCAR) is generally required to be completed once a bank’s total assets are above $50 billion. The objective of both exercises is to simulate a bank’s balance sheet performance and losses in a hypothetical severe economic downturn over the next nine quarters. Given this common objective, most risk managers consider and complete both exercises together.
In 2012, economists from the FHFA published a research paper describing a countercyclical approach for estimating the capital level required for mortgage portfolios to withstand future shocks to the housing sector. This approach uses state-level countercyclical stressed housing price paths (CSPs) based on where a state’s housing price levels are relative to its long-run trends and on the historical downside volatility of the state’s housing prices. FHFA has published a set of 51 of these 30-year CSPs (one for each state plus DC) starting from 13 different launch dates (each of the past 7 quarters—Q4 2013 through Q2 2015—as well as 6 quarters from 2003 to 2010). While the approach is not new, we believe it provides an interesting alternative to the Federal Reserve’s annual Dodd Frank Act Stress Test (DFAST) stressed housing price scenarios because it is more transparent and more granular. This paper compares FHFA’s CSPs to the DFAST stressed HPI scenarios and outlines an approach for applying the state-level granularity of the CSPs to national-level DFAST Severely Adverse scenario.
The data collected through the Capital Assessments and Stress Testing (FR Y–14) schedules provide the Federal Reserve with the information and perspective needed to help ensure that large bank holding companies (BHCs) have strong, firm-wide risk measurement and management processes supporting their internal assessments of capital adequacy. Information gathered in this data collection effort is used in the supervision and regulation of these financial institutions. Therefore, large BHCs should have internal controls that ensure the integrity of reported results.
The Federal Reserve Board (FAB) recently released regulatory guidance outlining its capital planning expectations for large financial institutions. The guidance addresses many areas of the capital planning process where regulators are looking for continued improvement within financial institutions and attempts to clarify differences in the Fed’s expectations based on firm size and complexity. The guidance is effective for the 2016 CCAR cycle.
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While the execution of robust model risk governance processes are critical for all financial institutions performing annual stress tests, in many cases, the successful delivery of DFAST 2016 results will depend on the institution’s ability to execute as a team and implement disciplined project management approaches.
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Capital is critical to a bank’s ability to absorb losses and maintain adequate liquidity. The financial crisis illustrated that the market’s confidence in the capitalization and overall financial strength of a bank can erode rapidly with changes in economic and financial conditions. This not only imperils the bank’s viability, but the broader financial system as well. For this reason, the Federal Reserve has made assessments of capital planning and analysis of capital adequacy on a post stress basis a cornerstone of its supervision of the largest and most complex financial institutions.
Adequate Capital, But Expect More Capital Planning Scrutiny
The 2015 CCAR results reveal that, while most BHCs have adjusted their portfolios and implemented models that produce quantitative results consistent with regulatory expectations, qualitative processes that support the capital planning process should expect continued regulatory scrutiny over the coming years.
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