This latest installment in our series about capital adequacy requirements discusses stress testing. This series was inspired by the FDIC’s recent announcement about a joint agency proposal revising the capital requirement framework for banks with total assets of $100 billion or more. The proposal would implement the final components of the Basel III agreement and further strengthen the banking system following the banking turmoil in March 2023.
Doran Jones believes this is a good time for banks to review their regulatory capital framework. In our experience, banks tend to focus on meeting the required amount of regulatory capital. We recommend that banks take a more wholistic approach to assessing their framework because that is exactly what the regulators are going to do when they perform an examination. According to the Office of Comptroller of the Currency, “The core assessment of a bank’s capital adequacy and the assignment of the capital component rating include an analysis of many different risks and factors, individually and in the aggregate, that affect a bank’s capital. Examiners’ assessments of capital adequacy consider the totality of a bank’s circumstances beyond meeting minimum regulatory capital ratios (i.e., the OCC’s conclusions on a bank’s capital adequacy may differ significantly from conclusions that might be drawn solely from an evaluation of compliance with minimum regulatory capital requirements).”
Regulators rate a bank’s capital adequacy based on each bank’s specific circumstances, not just minimum risk-weighted standards. Factors that affect a regulator’s capital adequacy rating include:
- Amount and quality of capital
- The bank’s overall financial condition
- The composition of the balance sheet, including intangible assets and the associated risks (concentration risk, market risk, etc.)
- The amount, composition, and trend of problem assets and the adequacy of related valuation reserves
- Access to credit markets and additional sources of capital
- The effectiveness of capital planning activities
- The risk level of off-balance sheet activities
- The amount quality and trend of earnings
- The bank’s growth strategy and track record of managing growth
In our experience, banks that are not subject to required self-stress testing often lack processes to analyze the impact of changing economic conditions on their capital adequacy to the degree that regulators expect.
Stress Testing
In 2019, the OCC adopted a final rule to amend the company-run Dodd-Frank stress testing requirements for national banks and Federal savings associations introduced in 2012. These amendments raised the threshold for required stress testing from $10 billion to $250 billion and reduced the testing frequency and number of required stress testing scenarios.
However, the OCC expects that “Community banks, regardless of size, should have the capacity to analyze key vulnerabilities and the potential impact of certain adverse outcomes on their capital adequacy.”
While formal stress testing for smaller institutions is not required, they are expected to have some sort of process assessing capital adequacy and market vulnerability that analyzes key risks under adverse conditions. Depending on the specific activities of the bank, such analysis could be expected to include regular, periodic sensitivity analysis of loan portfolios and interest rate risk exposure.
Such testing would typically involve an analysis of various scenarios and could include:
- transaction stress testing at the loan level to ascertain the impact of changing economic conditions
- portfolio stress testing to help identify potential vulnerabilities to the overall loan portfolio under changing economic conditions
- enterprise-level stress testing that considers the effects of credit, counter-party, interest rate and liquidity risk on the overall financial position of the bank under various economic scenarios
There is also an expectation that, if the results of the analysis indicate that capital ratios could become inadequate, that the bank would have a process to take such appropriate actions as:
- adjusting strategic and capital plans to lower risk
- enhanced monitoring of capital levels and market conditions
- limiting lending levels
- amending underwriting standards
- adjusting or hedging investment portfolios
- selling loans
- raising additional capital
Doran Jones Recommends
An annual review of the bank’s stress testing process to verify that it is appropriate for the bank’s activities and risk levels, and that they include:
- credible “what if” scenarios for key vulnerabilities
- reasonable estimations of the stress event’s impact on earnings and capital
- utilizing the results in the bank’s risk assessment process, asset management strategies, and strategic and capital planning process
It is particularly important to consider any material changes to the bank’s business (size, product mix, strategic plans, acquisitions, etc.) since the previous review.
Conclusion
It should not be surprising that, following the string of bank failures earlier this year, regulators are shining a spotlight on capital adequacy as a critical component of bank safety and soundness. Banks should be taking a proactive approach to reviewing their capital management processes and controls to avoid any unpleasant surprises when their regulators inevitably perform an in-depth examination.
Technology Considerations
Many banks, especially small- and mid-sized banks, are utilizing spreadsheet based EUCs to perform capital adequacy calculations. These spreadsheets need to be quite large and complex (often employing complex macros) and are very error-prone and inefficient. These spreadsheets are not only subject to data entry error but also errors resulting from erroneous spreadsheet logic, formulas, and links to outside data. In fact, studies by Raymond Panko at the University of Hawaii show that 90% of spreadsheets with more than 150 rows contain errors, and the European Spreadsheet Risks Interest Group estimated that more than 90% of all spreadsheets contain errors. Another risk associated with EUCs is that turnover can create a problem if critical knowledge of the EUC is lost.
These banks should be considering looking at tailored technology solutions to automate their capital adequacy processes that are tailored to their specific size, complexity, and business model. Such solutions can consist of basic financial risk automation (FRM) services to modular asset liability management solutions such as Moody’s that can be integrated with security trading platforms to monitor the volume, mix, maturity structure, interest rate sensitivity, and liquidity of the bank’s assets and liabilities that provides a comprehensive strategic planning and risk management solution.
Automated Regulatory Reporting using tools like AxiomSL are being used extensively by banks because of increasingly frequent, complex, and dynamic reporting requirements.
Doran Jones can provide the regulatory compliance and risk management expertise with extensive technological knowledge and experience to design and implement a cost-effective solution that will increase efficiency and lower risk by upgrading your risk and compliance systems or identifying and remediating gaps in existing processes.
Contact us to learn how a strategic partnership with Doran Jones can provide you with cost-effective solutions by leveraging our expertise with these and other critical risk and compliance functions.