Lessons Learned From The Fed Stress Tests

With Federal Reserve Bank stress testing requirements set to extend soon to midsize banks, what are the key lessons learned since the tests were implemented four years ago? What can be done better and where will the industry go from here?

Ever since the financial crisis of 2008-2009 nearly felled the entire U.S. economy, bank capital requirements have been top of mind for federal regulators. In addition to the passing of new legislation designed to prevent another collapse, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, regulators have been focused on making sure banks have enough capital liquidity to survive adverse or disastrous economic conditions.

In 2009, the Federal Reserve began doing just that, subjecting the nation's largest 19 banks to what have now become known as "stress tests," with the 2009 Supervisory Capital Assessment Program, and the subsequent annual Comprehensive Capital Assessment Review (CCAR). The stress tests have since been opened up to any bank with assets of more than $50 billion, which also have to complete a Capital Plan Review. This year, a new wrinkle has emerged as the Fed announced that banks with $10 billion to $50 billion in assets also will be subjected to a stress test, although they won't have as rigorous reporting requirements as do the larger banks.

The aim of all these tests is for banks to show they have sufficient capital to continue to lend to households and businesses even under severely adverse conditions, and are well prepared to meet Basel III regulatory capital standards as they are implemented in the United States, according to the Fed.

Since the tests were first implemented, banks have learned much about their own capital adequacy and regulatory compliance infrastructures. But there is still room for improvement, some experts say, and there are a number of measures banks can take to better comply with the tests and ensure they possess the necessary capital requirements. In many cases, along with taking steps to boost capital, banks have needed to make significant investments in risk management, liquidity assessment and modeling tools, as well as in the infrastructure required to support these kinds of high-performance systems.

And with smaller banks in the $10 million- to $50 billion-asset range now being subjected to the stress tests, a whole new set of questions arises as to how they will cope with this expanded regulatory scrutiny. In this report, Bank Systems & Technology takes a look at some of the lessons learned so far from the stress-testing process (including the kinds of technology investments that are related to compliance) and where the industry goes from here in regard to these capital requirement tests.

Know Thyself

Regardless of one's opinions about the necessity of the stress tests, most industry observers agree they have been helpful in enabling banks to get a better idea of their risk profiles.

"In general, we think these stress tests are a good idea, and they provide the opportunity for regulators to kick the tires, so to speak, of these institutions," says Tim Pawlenty, CEO of the Financial Services Roundtable, which represents 100 integrated financial services companies. "If it's done properly it can foster regulatory and market confidence."

Pawlenty, like others, believes the often-siloed nature of bank organizations has sometimes made it difficult for them to get true enterprise-wide views of their risk profile. Luther Klein, a managing director in the risk management practice at Accenture, agrees with that sentiment. He says there has been a shift in recent years toward centralizing resources at the enterprise level in order to comply with the stress tests. When the tests first began, Klein notes, many institutions had difficulty in aggregating their responses at the enterprise level because of organizational silos.

Another shift the industry has seen due to the Fed's stress tests is the implementation of sophisticated risk models, says Klein. "Over the last two to three years, the data and modeling capabilities have evolved," he adds. "Banks have better forecasting capabilities around P&L."

Jeff Sant, executive VP of sales and marketing and co-founder of Primatics, a software provider for financial institutions, also believes banks now have "much more sophisticated enterprise risk management departments" since the advent of the stress testing. "I think now they are asking the right questions," he says.

Although experts agree the industry overall has benefited from the stress tests in terms of learning more about its overall risk profile, some say there are things banks can do to better prepare for the tests. One of those things is not to simply try to figure out what metrics the Fed is looking for and provide them, which defeats the spirit of the exercise, Sant notes. "Don't just try and replicate what you think the Fed wants."

Further, notes Sant, banks should not think that passing a stress test the previous year means doing the exact same thing will be successful again. He adds that banks should not treat this process "like Y2K, as a one-time event to prepare for," but rather sustain the process going forward.

"The Fed wants to see continuous improvement," Sant says. "Many times, it's the banks that didn't do this very well four years ago that now have the best processes in place. And the ones who passed with flying colors the first year are now struggling."

Better Infrastructure

One side effect of the Fed stress tests is that they have forced banks to invest more in technology, such as analytics and data aggregation tools, and infrastructure related to enterprise risk management. Indeed, overall the Fed stress tests have spurred a massive change in the way the industry looks at enterprise risk management, says Adam Girling, a manager at Ernst & Young.

"It has been a colossal effort," he notes. "Banks have put a lot of specific infrastructure in place to deal with CCAR. But despite the pain, I think most people have found that this has been a useful exercise, especially for the management and the board level. It's forced the industry to invest in more robust stress-testing infrastructure, and firms have really learned something about their risk profile and capital adequacy."

Girling adds that the banking industry is far from done, however, when it comes to the evolving way it looks at risk and capital adequacy. Banks have invested in the infrastructure needed to deal with the requirements of the stress tests, he says, "but now they're looking hard at better systems, data controls and how to improve the efficiency and effectiveness of this process. Also, the vendor landscape is starting to catch up [to the stress test requirements], there is more availability of tools that have come on the market."

Further, though banks have been building the framework to do this over the past several years, they now must actually put that structure to work, notes Accenture's Klein. "It's not just about building the capabilities but figuring out how to use them. The processes have been set up and now banks are working on how to operationalize them."

Small Bank Stress

Perhaps the biggest change this year in the stress test process is the requirement that midtier banks be subjected to the tests. Even though banks in the $10 billion to $50 billion range won't be subjected to as intensive a process as the nation's largest banks are, there are still similar expectations that banks of this size will deliver the data the Fed is seeking, adds Ernst & Young's Girling.

"Even though their requirements may be a little less, there is still a significant investment needed to put the infrastructure in place, and not all of them will have it in place from day one," he says. "We'll probably see a few more years of investment as banks get up to speed."

Primatics' Sant says one fear is that many of the banks in this asset range will not be suitably prepared for the stress tests. Though they won't be subjected to as robust reporting requirements as the larger banks, many still won't be ready since they don't normally take into consideration how they might be affected by large, macroeconomic scenarios. On the other hand, Sant also notes that many smaller banks are far better capitalized than larger banks and not as systemically important to the national economy, meaning it could also be less likely they will fail the stress tests.

One thing that is likely to occur for banks of this size, however, is an increased investment in their risk management departments, Sant says. "Everyone will have to increase their fixed cost of compliance and that will squeeze some banks," he says.

The American Bankers Association, while supportive of the idea of stress testing as a tool for banks to understand and manage risk, believes the Federal Reserve needs to adopt a more flexible testing approach for banks with less than $50 billion in assets. In an April 2013 comment letter to the Fed written by the ABA's senior counsel, Hugh Carey, the industry group said the Fed must "clearly communicate expectations commensurate with an institution's size, complexity and familiarity with stress testing for smaller banks.

"Banks with $50 billion or more in assets previously participated in one or more of the Supervisory Capital Assessment Program (SCAP), comprehensive Capital Analysis and Review (CCAR) or Capital Plan Review (CapPR)," Carey writes. "Smaller banks have not participated in these processes and are not familiar with the agencies' expectations. As a result, these institutions do not know how best to comply with the proposed procedures." Further, the ABA recommends that the implementation date for smaller banks be extended to 2014, and that banks with a smaller geographic footprint be allowed to develop their own scenarios.

[Risk Management Must Be Priority For All Banks, Not Just The Biggest]

Like the ABA, the Financial Services Roundtable's Pawlenty agrees that these smaller institutions should not be subjected to the same rigor as big banks, but overall supports the idea of smaller banks being subjected to the stress tests. Pawlenty believes it is important to ensure that "banks of all sizes are sound" and that smaller banks can likely benefit and learn something about their market capitalization from the tests.

"Small banks can fail, too, and in some cases they have," he adds.

Another advocate for the concept that stress testing banks in the $10 billion to $50 billion range is ultimately a good thing for the national economy is Reetu Kholsa, a director at Pegasystems, which provides business process management and customer relationship management solutions. "If you take all the midtier banks and compile them together, the sum of all their parts is a big bank," she adds.

Kholsa also believes that being subjected to the stress tests will ultimately be good for banks of this size because it will force them to invest in better technology. Further, she suggests that being stress tested may actually provide a competitive advantage for these banks and make them more attractive to consumers because the fact that they have undergone and passed Fed capital requirement tests "brings credibility to the marketplace."

Bryan Yurcan is associate editor for Bank Systems and Technology. He has worked in various editorial capacities for newspapers and magazines for the past 8 years. After beginning his career as a municipal and courts reporter for daily newspapers in upstate New York, Bryan has ... View Full Bio