First take: CCAR stress testing
March 27, 2014
Ten key points from the Federal Reserve’s 2014 Comprehensive Capital Analysis and Review (CCAR)
"We think two to four [banks] won't be able to satisfy the Federal Reserve next week."
- Dan Ryan, PwC Financial Services Advisory Leader, Reuters (March 20, 2014)
The stress test results published yesterday (March 26th) as part of the Federal Reserve's third annual CCAR follow last week's release of Dodd-Frank Act Stress Test (DFAST) results. The major difference between DFAST and CCAR is that CCAR incorporates BHCs' proposed capital outflows and assesses capital planning processes. Four BHCs' capital plans were rejected yesterday due to qualitative process issues around capital planning and risk management, as we had anticipated last week in our Stress test first take: Ten key points from the Federal Reserve's 2014 DFAST.
- Fed raises the bar for the largest BHCs: Of the 18 original CCAR BHCs, the Fed objected only to Citigroup's capital plan. However, in doing so, the Fed sent the message that qualitative expectations continue to increase. Although the Fed stated that the bank has made progress with respect to its risk-management and controls (and its capital plan was accepted in 2013), the remaining deficiencies include the inability to project revenues and losses across complete global operations and the inability to develop scenarios that stress the firm's idiosyncratic risk across global exposures. The takeaway: even if one year's capital planning processes are deemed sufficient, they may not satisfy regulators the next year as the bar rises year-over-year (especially for the eight US G-SIBs). See PwC's Regulatory Brief, Stress Testing: Failures on the horizon? (November 2013).
- Quality of process trumps quantity of capital: Four out of the five rejected capital plans were based on the Fed's qualitative assessment of the BHCs' capital planning processes. Only one rejection was based on a quantitative deficiency (which was obvious from last week's DFAST results). The Fed's clear point is that since it has forced banks' capital positions to improve over the past few years, its focus is now on ensuring that the banks are implementing stronger and more sustainable stress testing processes. The Fed especially noted deficiencies in governance, controls, and modeling. Institutions were warned that process would be paramount in the Fed's capital planning guidance issued last August. See PwC's Regulatory Brief, Stress Testing: Midterm results improved, but it's all about the final (September 2013). Firms should heed the specific feedback that they will receive from the Fed within the next month (including upcoming MRAs).
- Half of foreign-owned BHC capital plans were rejected: Of the four banks that failed the Fed's qualitative process assessment, three are first time CCAR banks and all are foreign-owned US BHCs. Although the Fed stated that its expectations of these new CCAR banks is lower than its expectations of the largest and most complex BHCs, the overall CCAR processes and the sophistication of modeling approaches for the new CCAR banks will likely need work. The Fed is sending a specific message to the foreign BHCs that they are a part of the US regulatory regime.
- Half of the big six banks were unable to distribute desired capital, despite analysts' optimism: In addition to Citigroup, two more of the biggest banks (Bank of America and Goldman Sachs) were unable to release desired amounts of capital. However, like Amex last year, their difficulty was quantitative and not qualitative, so the two banks were able to quickly moderate their desired capital payouts to gain approval. The reality is that most of the top six banks show stressed Tier 1 Common ratios in the 6% to 7% range under DFAST, so these banks did not have a lot of room to distribute capital. Furthermore, most of these banks exhibited the greatest divergence among the 30 banks tested under DFAST between their own projected Tier 1 Common ratios and those projected by the Fed.
- Fed asset growth projections drove Tier 1 Common ratios downward: The Fed's projection of asset growth in the severely adverse scenario (for the first time this year) lowered Tier 1 Common ratios, as compared to the Fed's calculations last year and the BHCs' company-run calculations this year. Our preliminary analysis shows that the Fed's projected average RWAs exceeds the BHCs' forecasts by approximately 12% under Basel I and 8% under Basel III (for the period ending Q4 2015). The Fed's higher projected RWAs translates into approximately 80 basis point of Tier 1 Common dilution for the industry from last year, in line with our 50-100 basis point estimation in our Stress test first take issued last week. The Fed will continue to use this tool in its "black box" to keep capital in the system.
- Overall capital payouts only moderately increased from last year: When comparing capital dilution from 2013 to 2014 as a result of capital actions under CCAR, bank payouts only increased moderately from 80 to 110 basis points of the Tier 1 Common ratio.
- Capital planning enhancements pay off: Last year several firms were required to resubmit capital plans after making process enhancements. The firms' work was sufficiently robust, as evidenced by their withstanding of Fed scrutiny this year.
- More capital constraints are on the way: The trend after the crisis was toward de-risking of balance sheets, with RWAs as a percentage of assets declining from 2009 to 2012 (from 66% to 58%). However, 2013 saw the first uptick in RWAs post-crisis to nearly 62%, as the focus shifted from de-risking to optimization of the balance sheet. The optimal asset mix is still a moving target as it is still being defined by the combined impact of multiple developing regulations including CCAR, the Supplementary Leverage Ratio (SLR), the Liquidity Coverage Ratio (LCR), the Net Stable Funding Ratio (NSFR), and expected US rules regarding a capital buffer for G-SIBs, bail-in debt, and short-term funding capital penalties. While the revised capital framework and the LCR incentivize holding less risky assets, the SLR encourages holding riskier and higher-yielding assets. In addition, the upcoming full phase-in of AOCI as a capital deduction under Basel III (for Advanced Approaches firms) will create tradeoffs between the liquidity buffer's composition and the funding profile more broadly, creating incentives to substitute more sensitive longer-term assets for short-term investments (conflicting with the LCR and NSFR).
- Janet Yellen is taking charge: This year was the first time the Fed Board voted on BHCs' capital plans. The process is being centralized and reliance on others at the Fed is diminishing.
- The Fed is effectively centrally planning capital: The bifurcation of results into a quantitative portion (last week's DFAST) and essentially a qualitative portion (this week's CCAR with four rejected capital plans) allows the Fed to tout the industry's higher capital while sending the industry a message about its capital outflows and processes. Capital has increased quantitatively, but the qualitative bar continues to rise.