In their latest stress tests of systemically important banks, US regulators are reinforcing their focus on risk management, controls and governance, while differentiating more between complex and non-complex large firms. Justin Pugsley reports. 

What’s happening?

The Federal Reserve Board (FRB) and the Federal Deposit Insurance Corporation (FDIC) have announced the details of their Comprehensive Capital Analysis and Review (CCAR) programme, which is different in several ways to 2016’s exercise.

Some 34 of the US’s largest banks are being subjected to CCAR, with 21 of the less complex firms only involved in the quantitative part of the programme, thus escaping the qualitative evaluation bit for their capital planning processes. This makes the tests less onerous for these firms.

Reg rage - exasperation

Among the features of this year’s test are that some of the supervisory test models are to be enhanced and large foreign systemically important banks need to draft a capital plan, but will not face the full brunt of CCAR until 2018. Some chief financial officers will have to attest to the accuracy and completeness of their data. Also, the regulators want to see how banks have addressed outstanding regulatory issues.

A baseline and two stressful economic scenarios are being used, which are a little more demanding than last year; notably, there is no test for negative interest rates. The scenarios also simulate less US market volatility, but include a tougher commercial real estate market than last year.  

Why is it happening?

Federal Reserve chair Janet Yellen recently explained that these annual stress tests are to improve supervision and are a key part of the regulatory process, and the reason for the continued focus on risk management controls and governance is because the FRB and FDIC keep finding shortcomings in these areas within some of the banks. From the regulators’ perspective these tests are a good way to flush out these weaknesses and then force through improvements.

At the same time, regulators appreciate that there are different levels of risk between large, mainly domestic institutions focused on a few lines of business, and the big global systemically important banks that have fingers in many pies.

What do the banks say?

As usual the tests are demanding – more so than those conducted in Europe, for example. And there are several things banks dislike about the US ones in particular. First, they tie up a lot of capital – one estimate puts it at $230bn. Banks say this goes beyond the numbers stipulated in capital requirements rules.

The second main issue is that the scenarios tend to vary with every test, often in ways the banks find hard to predict. Daniel Tarullo, a governor at the FRB with responsibility for financial regulation, is seen as particularly arbitrary in his approach to setting the scenarios and the models. Bankers complain he does not interact enough with them and believe he uses the stress tests to gold-plate rules and capital requirements by the back door.

However, the FRB’s reply is that these exams are deliberately unpredictable so banks do not learn how to game them and therefore give regulators a false impression of systemic risks. 

The banks breathed a collective sigh of relief when Mr Tarullo resigned recently, effective from April 5, a move seen by many to result from the fact that he seems a poor fit with the new administration’s deregulation agenda. 

Will it provide the right incentives?

The regulator believes CCAR has been very useful and an opportunity for them to dive into the workings of complex systemically important financial institutions and understand what is going on inside them in a way very few outsiders can. They also get a valuable insight across the entire industry. It is widely viewed as an aspect of CCAR that should definitely be kept as it is a way of identifying potential risky herd behaviour and uncovering individual systemic weaknesses.

However, CCAR is very resource-intensive for banks, and there are probably ways to retain its best aspects while minimising the red tape. The fact that this year’s test makes some exemptions for less complex large banks shows regulators are perhaps starting to think along those lines.

Meanwhile, the scenario setting, which involves a lot of crystal ball gazing, might push banks and regulators to miss important risks. For instance, 2016’s negative interest rate simulation was wide of the mark, with US interest rates clearly on the rise. This year’s scenario of less volatile markets could also prove wrong. There are many reasons to believe it could be the opposite – particularly if the Fed ends up raising interest rates aggressively.  

The new administration has an opportunity to rethink CCAR so that it remains useful while being less onerous for banks.

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