Stress testing: Failures on the horizon?

November 2013
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Stress testing: Failures on the horizon?

At a glance

Regulators released capital stress testing guidance that continues to raise the bar for large firms and signals that more failing grades are likely in the future.

On November 1, 2013, the Federal Reserve Board of Governors (“Fed”), along with the Office of the Comptroller of the Currency, released documents pertaining to the capital stress testing requirements under the Dodd-Frank Act. One set of documents contained the stress test macroeconomic scenarios (i.e., baseline, severe, and severely adverse) and instructions that outline the economic parameters to be used by bank holding companies (“BHCs”) and by banks with over $10 billion in assets. Concurrently, the Fed issued the 2014 Comprehensive Capital Analysis and Review (“CCAR”) guidance that outlines revised requirements for BHCs with over $50 billion in assets whose capital plans would require Fed review.

Beyond the changes in the scenario parameters, these documents outline a number of other important updates, including accelerating the timeline for calculation of Basel III capital ratios. Furthermore, BHCs and banks with $10 billion to $50 billion in assets will be conducting supervisory stress tests in 2014 for the first time, while the results of stress tests for certain BHCs with over $50 billion in assets (i.e., those BHCs that were subject to capital plan review in 2013 but not to CCAR) will be publicly released. Taken together, these and others changes evidence our previously stated expectation that the stress testing bar will continue to rise for large BHCs and that more failing grades are likely in the future.

Looking across the scenarios, the range of parameters and shocks appear to leave no BHC or bank unscathed regardless of size. For example, although the 2014 severely adverse scenario outlines a protracted domestic recession similar to that assumed in 2013 scenarios, there are notably large declines in the housing price index (“HPI”), commercial real estate index, and in the global economy generally. The modeled change to HPI would impact firms from the largest BHCs to the larger regional BHCs, while the commercial real estate index changes would have a greater impact on the smaller BHCs. The modeled slowdown in developing markets and recessions in the UK, Europe, and Japan will have a greater impact on the largest banks and BHCs with a global footprint.

This Financial Services Regulatory Brief provides our view of the following:

  • The 2014 supervisory macroeconomic scenarios compared against prior years’ scenarios
  • The Fed’s introduction of a counterparty default component for eight BHCs with substantial trading or custodial operations
  • The incorporation of Basel III into firms’ capital estimates which introduces additional complexity and challenges
  • Additional implications of the 2014 supervisory stress testing framework

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