WASHINGTON – The 18 largest banks subject to a Federal Reserve stress test this year fell short in at least one of five areas the Fed says are critical to risk management and capital planning.
While many banking companies have improved capital planning techniques and raised capital levels, there is still considerable room for advancement across a number of dimensions, Fed supervisors said in a 41-page paper released Monday in Washington outlining weaknesses and successes in recent stress tests.
The Fed staff study shows that, after four such tests, some of the largest banks still lack comprehensive systems and policies to model, test, report and plan for economic calamities. While highlighting both strengths and weaknesses, the central bank said all of the bank holding companies faced challenges across one or more of five areas, and called for analysis tailored to each bank’s business and risk.
The Fed conducted its first stress test of the largest banks in 2009 to promote transparency of bank assets and reveal how much money they could lose in an adverse economy. Confidence in banks was low because portfolios were opaque, capital was scarce and job losses were rising as the economy succumbed to the worst recession since the Great Depression.
The KBW Bank Index, which tracks shares of 24 large U.S. financial institutions, has risen 25 percent this year compared with a 16 percent gain for the Standard & Poor’s 500 Index.
Areas where some banking companies continue to fall short of leading practice included not being able to show how risks were accounted for and using stress scenarios and modeling techniques that didn’t account for a bank’s particular risks. The Fed was critical of banks that generated projections for loss, revenue or expenses with approaches that were not robust, transparent, and/or repeatable, or that did not fully capture the impact of stressed conditions.
The Fed cited examples of capital policies that did not clearly articulate a banking company’s goals and targets and did not provide analytical support for how these goals and targets were determined to be appropriate. It also found examples of less-than-robust governance or controls around the capital planning process, including around fundamental risk-identification.
A common thread throughout the report is the importance of information systems to decision making. Banks that had strong information systems in place enabled them to collect, synthesize, analyze, and deliver information quickly and efficiently, the report said. Still, many banking companies have systems that are antiquated and/or siloed and not fully compatible, requiring substantial human intervention to reconcile across systems.
The Fed was also critical of favorable assumptions applied to assets and liabilities in a financial crisis. Examples of aggressive assumptions include large changes in asset mix that serve to decrease risk weights and improve post-stress capital ratios, a sudden inflow of low-cost deposits, and significant balance sheet shrinkage with no consideration of the kinds of losses the bank would experience selling those assets in a period of market stress.
The Fed conducts two types of tests. One, under the Dodd- Frank Act, takes a standardized look at how bank portfolios and capital might fare in an economic calamity, holding dividends constant with no stock repurchases. The second test – the Comprehensive Capital Analysis and Review – assesses bank planning to see if boards can adequately guide the use of capital through turbulent conditions, trimming stock buybacks and dividends if necessary.
Both Fed regulators and bank boards neglected to enforce capital conservation at the start of the financial crisis. The 19 largest banks in 2007 paid out more than $43 billion in dividends.