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."

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