The 2008 financial crisis exposed a number of critical weaknesses within the banking industry. Not only was the industry overleveraged and overexposed to a bubbling real estate market, but many banks also had a limited ability to effectively identify, measure, and control their risks and to assess their capital needs. Case in point, the continued capital distribution (e.g., dividend payouts) by many large Bank Holding Companies (BHCs) only highlighted the lack of required insight into stress conditions and its effect on a bank’s financial soundness (even after a substantial deterioration in the economic and financial markets).
In 2009, the Federal Reserve responded by initiating stress tests to measure the financial health of the 19 largest BHCs and to quantify the potential effect on their capital in a deteriorating economic environment. Initially referred to as Supervisory Capital Assessment Program (SCAP), the Federal Reserve used a wide range of inputs, including data collected from the banks, a baseline economic scenario, an adverse economic scenario, and supervisory judgment to project revenues, losses, and capital levels. The initial test found that nine of the 19 BHCs had sufficient capital to get through the adverse economic scenario; however, the remaining 10 companies needed to add $75 billion – collectively – to reach a required capital level. Nine of those banks were able to fulfill their additional capital needs through the private market. SCAP was a significant contributor to stabilizing the banking industry, but, more importantly, it set the stage for a broader and more effective program.
In 2011, the Federal Reserve initiated the Comprehensive Capital Analysis and Review (CCAR), and shortly thereafter, the complementary Dodd-Frank Act Stress Test (DFAST). Now an annual exercise, it includes stress testing through a common set of economic scenarios (e.g., housing bubble burst, unemployment increase, stock market crash, severe GDP drop, etc.) and models to determine whether a BHC has sufficient capital to absorb losses, support operations, and meet its proposed capital plan (e.g. dividend payouts, dividend hikes and share buybacks). Furthermore, it assesses the BHC’s own practices for determining capital needs, including their practices around risk measurement and management, capital planning and decision making, and, lastly, the internal controls and governance around these practices. If a BHC meets expected criteria, they can announce their capital plans to their shareholders. In March 2015, 29 of 31 BHCs met the criteria without any objections.
In a few short years, programs such as SCAP and CCAR have not only played a significant role in guiding BHCs to stability, but also have helped them build capital. In fact, since the 2008 financial crisis, BHCs have nearly doubled their capital levels—increasing by $641 Billion to over $1.1 Trillion by the end of 2014.
In my next set of posts, we’ll explore CCAR further and provide guidelines and best practices for complying with this annual assessment.