by Shannon Lois
These are challenging times for large financial institutions. Still feeling the impact from the financial crisis of 2007, the banking industry must endure increased oversight, declining margins, and fierce competition—all in a lackluster economy. Financial institutions are especially subject to closer regulatory scrutiny.
As part of this stepped-up oversight, the Federal Reserve Board (FRB) conducts annual assessments, including “stress tests”, of the capital planning processes and capital adequacy of BHCs to ensure that these institutions can continue operations in the event of economic distress. The Fed expects banks to have credible plans, which are evaluated across a range of criteria, showing that they have adequate capital to continue to lend, even under adverse economic conditions. Minimum capital standards are governed by both the FRB and under Basel III. The International Basel Committee established the Basel accords to provide revised safeguards following the financial crisis, as an effort to ensure that banks met capital requirements and were not overly leveraged.
Using input data provided by the BHCs themselves, FRB analysts have developed stress scenario methodology for banks to follow. These models generate loss estimates and post-stress capital ratios. The CCAR includes a somewhat unnerving hypothetical scenario that depicts a severe recession in the U.S. economy with an unemployment rate of 13%, a 50% drop in equity prices, and 21% decline in housing market. Stress testing is intended to measure how well a bank could endure this gloomy picture.
Between meeting the compliance requirements of both BASEL III and the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR), financial institutions commit sizeable time and resources to administrative tasks that offer few easily quantifiable returns. Nevertheless—in addition to ensuring they don’t suddenly discover themselves in a trillion-dollar hole—these audit responsibilities do offer some other benefits and considerations.