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Tuesday, September 27, 2016

USA - After five years of post-crisis stress testing, we believed it was important for us to conduct a more thorough assessment of the program. Taking advantage of the shift in timing of the annual stress tests following the 2015 cycle.. - FED

Press Release - Governor Daniel K. Tarullo - At the Yale University School of Management Leaders Forum, New Haven, Connecticut - September 26, 2016

Next Steps in the Evolution of Stress Testing

Supervisory stress testing has become a cornerstone of post-crisis prudential regulation. Stress testing, unlike traditional capital requirements, provides a forward-looking assessment of losses that would be suffered under adverse economic scenarios. The simultaneous testing of the largest firms lends a perspective on a large part of the banking system and facilitates identification of common exposures and risks.

During the financial crisis, the success of an ad hoc stress test in assessing the capital needs of, and restoring confidence in, the nation's largest financial institutions encouraged Congress to make stress testing a required and regular feature of large firm prudential regulation.1 The Federal Reserve has, in the succeeding years, substantially refined its supervisory stress test. Moreover, the stress test has been integrated into our Comprehensive Capital Analysis and Review (CCAR), which both ties the results of the test into the banks' capital distribution practices and evaluates their risk management and capital planning capacities.

Today I want to share with you the results of an extensive review of the statutory stress test and CCAR programs, which we began following the end of the 2015 cycle. Before turning to the reasons for that review and some ideas for changing these programs that have arisen from it, I will take a few moments to summarize the characteristics and purposes of the programs as they have evolved to this point.

Stress Testing and CCAR Today

As we have implemented the requirement mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) for stress testing--which the Federal Reserve denominates as the Dodd-Frank Act Stress Test (DFAST)--that exercise includes four main steps.2 (1) The firms subject to DFAST provide the Federal Reserve with detailed, significantly standardized data on their loans, securities holdings, trading positions, counterparty exposures, revenue, expenses, and balance sheets. (2) The Federal Reserve specifies hypothetical macroeconomic and financial market scenarios--including an "adverse" and a "severely adverse" scenario. (3) The Federal Reserve inputs the data from the firms into its own supervisory models to project each firm's losses, revenues, and capital over a nine-quarter planning horizon under the specified scenarios. (4) The results of the exercise, including the capital positions of the firms following the hypothesized stress scenarios, are disclosed to the public.

As DFAST has evolved, it has become an increasingly valuable tool for evaluating whether the largest financial firms are holding sufficient capital to continue providing credit in the event of significant macroeconomic and financial stress. However, in itself DFAST does not set any capital ratios or limit any capital actions by the firms. Those functions are implemented through the CCAR program, which was created through the regulatory process by the Federal Reserve.3 In CCAR, the Federal Reserve assesses the overall capital adequacy of the firms--including evaluations of whether each firm's capital provides an adequate buffer for the losses that would be incurred during the stress scenarios, whether its risk management and capital planning processes are appropriately well-developed and governed, and how its plans to distribute capital through dividends or share repurchases could affect its ability to remain a viable financial intermediary in the hypothesized scenarios. Given how central these considerations are to effective risk management and the soundness of these firms, we are progressively integrating the qualitative elements of CCAR into our year-round supervisory program for the largest banking organizations.

Under CCAR, the Federal Reserve may object to a firm's capital plan on either quantitative or qualitative grounds. A quantitative objection is made when the stress test reveals that a firm would not be able to maintain its post-stress capital ratios above the regulatory minimum levels over the planning horizon, taking into account its planned capital distributions. We have taken planned distributions into account because, as the run-up to the financial crisis revealed, firms may be reluctant to cut their distributions--particularly dividends--even in a period of growing stress. Thus, CCAR included what has been called a "pre-funding" requirement.

The Federal Reserve may object on qualitative grounds if it finds that the firm's capital planning processes are not sufficiently reliable. The qualitative assessment includes the assumptions and analyses underlying each firm's capital plan, its controls and governance processes, and whether previously identified weaknesses in management and operations have been corrected. If the Federal Reserve objects on quantitative or qualitative grounds, the firm may not make any capital distributions without our permission. In practice, in the case of a qualitative objection, we have generally permitted distributions at the previous year's level but no increases. This practice, however, has been in the context of distributions rising from generally low levels coming out of the crisis; there has been no guarantee that a similar practice would prevail as distributions continue rising.

The quantitative component of CCAR, based as it is on the DFAST stress tests, has contributed to the continued strengthening of the capital levels of the largest financial institutions that began after the original stress test in the winter of 2009.4 While, understandably, many focus on the quantitative side and its implications for capital distributions, the importance of the qualitative component has been perhaps underappreciated. We saw during the 2009 stress test that many large financial institutions were unable to marshal the data necessary to gauge their own exposures accurately or to project the adverse effects they would suffer in a tail event, as opposed to a more ordinary cyclical downturn. CCAR has required the firms to steadily improve their risk management and capital planning processes. Indeed, some of the firms--particularly the less complex banks within the CCAR cohort--are now meeting, or are close to meeting, our supervisory expectations across a range of risk management and capital planning processes.

Copyright: Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue N.W.
Washington, D.C. 20551

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