The Federal Reserve recently released the results of its latest stress test of large bank holding companies (BHCs). While the stress test results have received a lot of attention, they are just one part of a much larger effort by the Federal Reserve to ensure that these large BHCs have robust processes for determining how much capital they need to maintain access to funding and continue to serve as credit intermediaries, even under stressed conditions. In this post, I describe these larger efforts and the role that the stress test plays in them.
What Is the CCAR?
The Comprehensive Capital Analysis and Review (CCAR) is the Federal Reserve’s primary supervisory mechanism for assessing the capital adequacy of large, complex BHCs. Following the adoption of the “capital plans rule” in November 2011, all U.S.-domiciled, top-tier BHCs with assets of $50 billion or more are required to develop and submit annual capital plans to the Federal Reserve. In 2012, the CCAR covered the 19 BHCs that participated in the Supervisory Capital Assessment Program (SCAP), the initial set of systematic stress tests conducted by the Federal Reserve in 2009. (The capital plans of the other eleven BHCs subject to the capital plans rule were evaluated through a separate process.)
The capital plans describe the processes used by these large BHCs to ensure that they have sufficient capital to continue to serve as credit intermediaries and to provide key financial services even under very adverse economic and financial market conditions. Under the terms of the capital plans rule, the plans submitted to the Federal Reserve must include several elements:
- A detailed description of the BHC’s process for assessing capital adequacy, including a discussion of how the BHC will maintain capital ratios above regulatory minimum levels and a tier 1 common ratio above 5 percent under both expected and stressful economic conditions;
- The BHC’s capital policy—the guidelines, principles, and governance procedures used for capital planning, including determining the amount of capital distributions such as dividend payments and share repurchases;
- A description of the BHC’s planned capital actions, including plans for dividend payments, share issuance and repurchases, and any other actions that would affect its capital resources; and
- The BHC’s own assessment of the sources and uses of capital over a nine-quarter planning horizon under both expected and adverse economic conditions.
An important feature of the capital plans is that they are explicitly forward-looking. The plans focus not just on the BHC’s current regulatory capital ratios, but also on assessments of what might happen to its capital in the future under both expected and stressful economic conditions. This forward-looking assessment is important because regulatory capital ratios do not always adjust rapidly as market conditions and perceptions about the firm change, especially during times of stress. The CCAR’s forward-looking assessment is meant to provide insight into the robustness of each BHC’s capital adequacy process and capital position under stressful conditions, and to ensure that the BHC’s plans for distributing capital back to its shareholders via dividends and share repurchases are consistent with the firm’s continued financial health under those conditions.
Stress Tests and the CCAR
As part of its assessment of the capital plans in CCAR 2012, the Federal Reserve made its own projections of each BHC’s losses, revenue, and capital under a hypothetical set of very adverse economic conditions–these are the “stress test” results published by the Federal Reserve on March 13. The BHCs also made a series of stress test projections that were included in their capital plans. Both the Federal Reserve and the BHCs generated stress test results based on a hypothetical economic scenario developed by the Federal Reserve featuring a deep recession in the United States, a slowdown in global economic activity, and sharp declines in asset prices. This “supervisory stress scenario” is not a forecast, but a hypothetical scenario designed specifically for assessing the strength and resilience of BHC capital in very adverse economic conditions. The BHCs also generated stress test results based on a “baseline” scenario provided by the Federal Reserve and on their own adverse and baseline scenarios.
Importantly, the capital ratios calculated by the Federal Reserve and the BHCs under the supervisory stress scenario contained the capital distributions specified in each BHC’s capital plan under a baseline scenario. This means that the Federal Reserve’s evaluation was particularly stringent, since it did not assume that BHCs reduced their dividends or share repurchases in the face of very adverse economic conditions.
The CCAR and the capital plans rule focus on the BHCs’ internal capital planning and management processes and on ensuring that these are robust and well-governed. Along with each BHC’s stress test results, the Federal Reserve’s independent stress test projections were a key input into the assessment of whether BHCs would be able to make their planned capital distributions while maintaining capital ratios above regulatory minimum levels under stressful economic conditions. This assessment was one of the critical aspects of the CCAR 2012 analysis, but it was not the only important element. As recently noted in a speech by Federal Reserve Governor Daniel Tarullo, the CCAR “is about more than using a stress test to determine whether a firm’s capital distribution plans are consistent with remaining a viable financial intermediary even in an adverse scenario.”
The Federal Reserve’s evaluation of the capital plans in CCAR 2012 involved a broad examination of the comprehensiveness of the plans and the reasonableness of their assumptions and analysis. In particular, the Federal Reserve’s review assessed whether the analysis captured the risks stemming from the full range of each BHC’s activities and business areas, whether there was sound internal governance over the capital adequacy process, and whether the BHC has effective models and methods for determining the impact of different economic and financial market conditions on losses, revenue, and capital. Analysts also reviewed each BHC’s capital policy to ensure that the policy clearly specifies the BHC’s principles in managing its capital and determining the appropriate levels of capital distributions consistent with maintaining a strong capital position. Finally, the Federal Reserve also assessed each BHC’s ability to make steady progress towards meeting the regulatory capital standards agreed to by the Basel Committee on Banking Supervision (“Basel III”) as they would come into effect in the United States over time.
At the end of the CCAR process, each BHC was told whether or not the Federal Reserve had any objection to its capital plan. The Federal Reserve’s decision was based on all of the elements in the plan. In other words, some aspects could be strong, but the Federal Reserve might still object to the plan as a whole based on weak performance in other elements. In particular, both the BHC’s and the Federal Reserve’s stress test results could suggest that the BHC’s capital ratios under stress would remain above regulatory minimum levels, but the Federal Reserve might object to the plan for other reasons, which might include weaknesses in the BHC’s risk measurement and management systems, weaknesses in governance over the BHC’s capital adequacy process, an inadequate or poorly implemented capital policy, or problems with other critical aspects of the BHC’s capital planning process.
Under the terms of the capital plans rule, if the Federal Reserve objects to a BHC’s capital plan, then the BHC may not make any capital distributions unless the Federal Reserve specifically indicates that it does not object to the distribution. BHCs are required to resubmit an updated and revised capital plan if the Federal Reserve objects to the plan, or at any time if the Federal Reserve determines that there was been a material change in the BHC’s risk profile, financial condition, or corporate structure. The goal of this process is to ensure that all large, complex BHCs have in place capital plans that reflect their current business and risk profiles and financial condition, and that the underlying processes described in the plan robustly support the BHCs’ decision-making about capital distributions and capital adequacy. The Federal Reserve’s stress test results are an important input, but they are just one of many factors considered in evaluating the BHCs’ capital plans.
The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.