Moody's Analytics Highlights Key Questions Ahead of Today's CCAR Results (BAC) (JPM) (C) (WFC) (XLF)

Ahead of CCAR results later today, Moody's Analytics Ed Young and Anna Krayn highlighted ‘Five Key Items to Consider in the Fed’s Stress Tests’, reviewing key concerns and addressing common questions:

1. What is the difference between the Fed’s Comprehensive Capital Analysis and Review (CCAR) and the Dodd-Frank Act Stress Test (DFAST)?

There are a couple of distinct segments of the Fed’s oversight of capital adequacy for large firms. The table below highlights a few key differences between the two stress testing exercises used for the review.

2. What is the qualitative portion of the review?
The qualitative review is an important component of CCAR, and has accounted for thea majority of the Fed’s capital plan objections over the last three CCAR cycles. The review focuses on risk management and governance of the capital planning process of each CCAR firm. The Fed reviews elements such as data quality, risk identification, forecasting processes, capital policies, and internal controls to ensure the firms have a sound capital adequacy process. A key focus is on management’s dividend and share repurchase decisions, ensuring enough capital is retained to cover risks in a stress environment.

3. What is different about the qualitative review in 2016?

A majority of the items the Fed will cover in the qualitative review this year are similar to past CCARs. However, there are a few items to consider as we anticipate the results of this year’s review.

As enterprise-wide stress testing processes mature across the industry, the Fed’s minimum expectations (to avoid an objection) tend to increase each year. In the past, expectations around loss modeling, capital policy, and model risk management have been key sticking points for some firms. This year, we anticipate risk identification, process integration, and scenario design to be key areas of focus of the Fed’s concern. In other words, the Fed will be trying to determine if each bank has its arms around all of the different types of risks it may face, from extreme currency fluctuations for firms with extensive international operations to the effects of a commercial real estate bubble for those with large loan portfolios in the sector. Additionally, the Fed will focus on transparency of the end-to-end capital planning process, from loss modeling for various portfolios to dividend payout decisions.

The Fed issued detailed supervisory guidance on capital planning and positions for large firms in late 2015. This guidance significantly enhances the transparency of its expectations for firms of various size and complexity. The “tailoring” of expectations will most likely lead to greater scrutiny of the largest banks for areas like management oversight, data quality, and sensitivity analysis of scenario results.

4. Was “Brexit” impact considered in the stress test?

Not necessarily. The Fed’s stress scenarios include a hypothetical market shock component for firms with large trading operations. Additionally, all firms must construct a stress scenario that uniquely addresses their own vulnerabilities. It is likely that firms with significant market risk exposures incorporated the impact of an event similar to Brexit in their scenario.

Brexit is just another example of a long list of unexpected shocks to financial firms. Market stresses, operational events like system failures or data breaches, adverse interest rate movements, and the like are a constant threat to financial firms. This is why in the capital planning guidance, the Fed emphasized the importance of running a wide range of scenarios frequently to assess and mitigate any significant vulnerabilities. We will continue to see firms work to develop more a robust and efficient infrastructure to handle the operational strains of conducting enterprise scenario analysis on a frequent basis.

5. What do you expect to be the overall takeaways from CCAR 2016?

After reviewing the DFAST results and using recent history as an indicator, we expect a majority of the issues identified by the Fed to be centered on qualitative deficiencies. However, trying to predict the exact number of qualitative failures and specific reasons for each in any given year is guesswork due to the sheer number of variables inherent in each decision.

One thing is certain: As the industry continues to coalesce around best practices for enterprise stress testing, the Fed’s expectations will continue to rise for all firms. Nevertheless, with the Fed’s clarified supervisory guidance and focus on tailoring expectations based on size and complexity, we expect identified deficiencies to be related to risk identification, process transparency, and governance for firms designated as Large and Complex. Time will only tell if these deficiencies will lead to a capital plan objection for any of the firms.

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