US Regulatory Stress Testing Implications for Large Banks Michael Jacobs, Ph.D., CFA Senior Manager Deloitte & Touche LLP Audit & Enterprise Risk Services Government, Risk and Regulatory Services November 2013 Pace University GARP Chapter Meeting

Executive Summary

Regulatory Expectations & Timelines

Implications for Banks

Stress Testing Methodology and Processes

Guidance and Key Considerations

Industry Observations and Emerging Practices

Agenda

• Executive Summary Regulators setting higher standards on Banks's internal capabilities for assessing and stress testing capital adequacy as integral part of their overall risk management and capital planning framework

• Capital planning has become the key tool of US supervisors for monitoring and managing financial system and bank level soundness and stability

• Stress testing and CCAR has gone through multiple iterations and evolved significantly over time

• Recent rulemaking and guidance have set high expectation on the Bank’s framework for stress testing and capital planning processes, system and governance

Regulations

Implications to

Banks

Road Ahead

• Institutions need to significantly upgrade their capabilities to conduct periodic stress testing

• Establish effective governance mechanism, board approval, internal management review, accountability and transparency

• Implement systems, processes and controls to help provide the availability of consistent, high-quality risk data that can easily be aggregated across their organization.

• Large scale effort, which spans across the enterprise, with significant data sourcing, aggregation and processing needs to meet CCAR annual reporting and other business/regulatory needs

• Iterative validation and reconciliation efforts requiring intense manual intervention, to provide consistency across various regulatory requirements

• Integrating CCAR into the overall risk management and capital planning process

• Evolving US banking regulatory landscape

• Basel II introduced Pillar II Supervisory Guidance on Capital Adequacy, which I continued and enhanced in Basel III

• Requirements of Pillar II were detailed in the ICAAP guidance and include in the use of stress testing

• SCAP put forward the prescriptive requirements for 19 banks during 2009 which are in turn leveraged in later stress testing requirements

• CCAR formalizes regulatory expectations and provided fairly prescriptive guidance

• Identifying, measuring, monitoring and managing model risk is a critical component of effective stress testing framework

• The five stress testing principles established whereby banks should sensitivity analysis, reverse stress testing, scenario analysis

• Enhanced prudential standards enshrines stress testing as regulatory tool for capital adequacy

2012

2007

2011

2009

Stress testing and capital planning have become the key tool of US supervisors, especially Fed, for monitoring and managing financial system and bank level soundness and stability. These requirements have significantly evolved over time.

2013

Basel II

Basel III

ICCAP SCAP

CCAR Model Validation

Stress Testing Validation

CCAR / CapPR (Capital Plan)

RESOLUTION PLANS

ENHANCED PRUDENTIAL STANDARDS

CCAR 2013

Guidance

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US Capital Regulations

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Linkages amongst various regulations Given the overlapping nature of regulations, institutions need to take a broad and integrated view of regulatory capital

Regulatory Capital

Stress Testing

Enhanced Prudential

Supervision • CCAR • Living Wills • Contingency plans

• Governance • Early Remediation • Counterparty

limits

• Basel II / II.5 / III • ICAAP • Economic Capital • Collins Amendment (floor)

• Early remediation framework is based on capital ratio thresholds

• Oversight and governance of ICAAP is aligned with requirements under Enhanced Prudential Supervision

• Credit exposure calculation for counterparty limit is aligned with EAD calculation

• Projected capital ratios are a key component of stress test results

• Capital plan approval is based on projected capital ratios

• Capital amount / ratios are a key input to resolution and contingency planning processes

CCAR Mission Forward-looking supervisory assessments to ensure determine that banking organizations are adequately capitalized

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“From a micro prudential perspective, the CCAR provides a structured means for supervisors to assess not only whether banks hold enough capital, but also whether banks are able to rapidly and accurately determine their risk exposures, an essential element of effective risk management. The cross-firm nature of the stress tests also helps supervisors identify outliers--both in terms of results and practices--that can provide a basis for further, more targeted reviews”

By Chairman Ben S Bernanke, April 8, 2013

CCAR Overview Supervisory assessment based on a combination of quantitative results from stress tests and qualitative assessment of the capital planning processes used by banks

• In November 2010, the Fed issued guidelines requiring 19 large BHCs with total assets of $50B and above to participate in the CCAR 2011 process

• In December 2011, the Fed issued the Capital Plan rule formalizing the evaluation of capital adequacy on an annual basis

• CCAR 2011, has been followed with CCAR 2012 and CCAR 2013 – in alignment with the Dodd Frank Act’s requirements for annual capital adequacy assessment and stress testing requirements

Federal Reserve (Fed)

Rulings

Objectives of CCAR

• Ensure that institutions develop and demonstrate robust, forward-looking capital planning processes that account for their unique risks

• Ensure that institutions establish sufficient capital to continue operations throughout times of economic and financial stress.

• Evaluate and approve/object to capital distribution plans proposed by institutions, based on the supervisory assessment of capital sufficiency and strength for each institution

Background

• In February 2009, the Fed mandated 19 BHCs to participate in its Supervisory Capital Assessment Program (SCAP) that involved stress testing under two scenarios.

• This exercise contributed to gaining in-depth assessment of the financial system and provided lessons that were included in the Stress Test Rule of the 2010 Dodd-Frank Act

• Deficient BHCs were subjected to specific actions to raise capital, including through the U.S. Treasury’s Capital Purchase Program or Capital Assistance Program

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Application of Rules and Timelines

BHC Type Key Requirements Timing of Rules Application

US BHC with global assets $500B or more (6 banks with large trading activities)

• Submission of annual capital plans, with stress tests using supervisory Baseline, Adverse, and Severely Adverse and company scenarios (as at Sept 30, due Jan 5 each year) • Required to run additional market risk shock scenarios • Subject to supervisory stress tests on annual capital plans • Submit FR Y-14 reports (including trading & counterparty schedules) • Mid-year company-run stress tests (as at Mar 31, due July 5 each year) • Publication of annual capital plans and mid -year stress tests within 90 days

• Already fully in effect, including publication of results

Other Original SCAP Banks (12 banks with assets $100B or more)

• Same as above, except: o Not required to run additional market risk shock scenarios o Not required to submit detailed FR Y-14 trading & counterparty schedules

• Already fully in effect, including publication of results

Other US BHCs $50B or more (12 banks) • Same as other original SCAPs

• Were required to submit full 2013 capital plans • Supervisory stress tests and publication of results starts from 2014 plans (fall 2013)

US BHCs $10B-$50B • Completion of annual stress tests using supervisory Baseline, Adverse, and severely Adverse scenarios (as at Sept 30, due Mar 31 each year) • Publication of company run stress test results for Severely Adverse scenarios within 90 days of submission

• Starts from fall 2013, including publication of results

FBOs with $50B or more in US assets (excl. branches)

• Required to establish US Intermediate Holding Company for US assets • Same as US BHCs $50B or more

• Starts from July 2015

FBOs with $10B-$50B in US assets (excl. branches)

• Required to establish US Intermediate Holding Company for US assets • Same as US BHCs $10B-$50B

• Starts from July 2015

Multiple rules and/or additional guidance by Fed embeds stress testing as a cornerstone of the U.S. supervisory regime. Below is a summary of the capital planning and stress testing rules and timelines for their application by type of US banking institution.

Qualitative Considerations • Robustness of BHC’s capital adequacy assessment process, including corporate

governance, controls and risk-measurement & management practices • Reasonableness of assumptions and analyses underlying the BHC’s capital plan • Review of proposed capital distributions for sound practices • Determine that no outstanding material, unresolved supervisory issues

2013 Stress Test: Stress Test & Capital Plan Results

FRB Assessment Criteria

Quantitative: Minimum regulatory ratios

Tier 1 Common ratio 5%

Tier 1 Leverage ratio 3% or 4%

Tier 1 risk-based Capital ratio

4%

Total risk-based capital ratio 8%

2013 CCAR Assessment

Results

• 17 of 18 BHCs maintained capital above regulatory minimums in severely adverse scenarios • Objections to capital plan of 2 banks: One on qualitative grounds (BB&T Corp) and the other on both

quantitative & qualitative grounds (Ally Financials Inc.) • Conditional non-objection to capital plan for 2 BHCs (JP Morgan Chase &Co. and The Goldman Sachs

Groups, Inc.), owing to weaknesses in their capital plan or capital planning process • 2 BHCs required to submit adjusted cap actions as they had at least one minimum post-stress capital

ratio fall below regulatory minimum levels based on the original planned capital actions (American Express Company and Ally Financial Inc.)

2013 CCAR Observations

• Minimum level of all four capital ratios significantly below the third-quarter 2012 value, with declines ranging between 2.7 and 5.0 percentage point. There is considerable variation across BHCs in the extent of the decline.

• Aggregate Tier 1 Common ratio fell 458 basis points post stress • Aggregate Tier 1 leverage ratio fell 273 basis points post stress • All 18 BHCs are on a path to successfully meet the Basel III requirements

Brief recap of CCAR 2013 Stress Testing Results and key highlights

Regulatory Expectations

Institutions are expected to establish sound risk measurement and infrastructure supporting identification,

measurement, assessment, and controls

Translate risk measures into estimates of potential losses over a range of stressful scenarios and environments

Use defined capital resources and estimation over the same range of stressful scenarios and environments used

for estimating losses

Capital planning and composition should be integrated with estimates of losses and capital adequacy

Establish a comprehensive capital policy and robust capital planning practices for establishing capital goals

Develop robust internal controls governing capital adequacy components, including policies and procedures;

change control; model validation and independent review

Effective Board and senior management oversight on Capital Adequacy Process (CAP), periodic reviews of risk

infrastructure, methodologies

Regulatory expectations continue to evolve from initial SCAP to more prescriptive CCAR and SR 12-07 (i.e. BHC > $10 B)

Supervisory Guidance

SR – 99 – 18

U.S. Basel II Pillar II and ICAAP

SCAP

Model Validation (SR 11-7, OCC 2011-12)

CCAR / CapPR for 2012 (published in 2011)

Supervisory Guidance on Stress Testing (SR12-7), May 2012

CCAR/ CapPR 2013 guidance (published in 2012)

• SR 99-18 put forward the notion of assessing own internal capital adequacy, including the use of economic capital and stress testing

• Basel II introduced Pillar 2- Supervisory Guidance on Capital Adequacy

• Requirements of Pillar 2 introduced in Basel II were detailed in the ICAAP guidance and included the use of stress testing

• SCAP put forward the prescriptive requirements for 19 banks during 2009, which are in turn leveraged in later stress requirements

• Identifying, measuring, monitoring and managing model risk. This letter is guidance applicable to models used as part of stress testing framework

• CCAR formalized regulatory expectations and provided fairly prescriptive guidance associated with the role of stress testing and capital management, capital adequacy processes, and planning

• The five stress testing principles are broadly consistent with the principles outlined for CCAR/CapPR institutions. They are applicable to financial institutions that are $10 billion and above and also require banks to calculate sensitivities, complete reverse stress tests and complete scenario analysis

• The CCAR/ CapPR 2013 guidance (published in 2012) reinforces the 2012 guidance (published in 2011) and provides additional clarifications based on regulatory findings during the 2012 stress testing process on the principles and requirements previously outlined

Key areas of focus Rules & Guidance

SR-09-04 • SR-09-04 linked dividend payment with elements of capital planning process such as identification

of risks e.g. capital shortfall due to losses in a stress scenario

FRY-14 Guidance • FRY-14 mandates reporting of quantitative projections of balance sheet, income, losses, and capital across a range of macroeconomic scenarios

Typical CCAR Processes

Risk Identification and Extraction Analysis, Review and Processing Reporting Schedules (for Submission)

Product / Portfolios Information

- Retail Exposures (Revolving/ Instalment)

- Commercial Exposure - Other

Macro Variables (Per Economic Scenarios) FR Y 14 M (Retail

Schedules) Credit Card Address Matching First Mortgage Home Equity

FR Y 14 Q Schedules

• Basel III and DFA • Retail • Trading • Wholesale • Securities • Operational Risk • Pre Provision Net

Revenue • Regulatory Capital

Instruments

Bank holding companies (BHCs) need continuous program to undertake Federal Reserve requirement towards submission of Comprehensive Capital Analysis and Review. BHCs need coordinated and cross functional effort, given below is generic functional view for understanding

FR Y-14A • Summary • Macro Scenario • Counterparty Credit Risk (CCR) • Basel III and Dodd Frank • Regulatory Capital

Risk Information (Ratings, Collateral,

Segments)

- Retail Risk Parameters (Internal and External)

- Commercial Involved Party - Other

Historical Information

- Delinquency - Payments - Charge off and Recovery

Finance Information

- IMPR Hierarchy - Balance Sheet Information

Banks uses Fed. scenarios & develops proprietary macro variables

Balance Forecasting

- Balances are forecasted for 9 Quarters - Baseline is taken from Finance Information - Line Items / Segmentation for Loan Balances is defined

Loss / Provisions (Projections)

- Credit Loss Models are developed and validated per methodology

- Portfolio specific Models are executed for Loss Projections

Banks Capital Plan

Review & Approve

- Internal Reviews - Board Reviews - Challenge Process - Approval Process

ICCAP Documentation

- Statement of Risk Appetite

- Capital Adequacy - Capital Forecast - Liquidity Planning - Aggregation and

Diversification - Model Validation

Report - Governance

Capital Planning Process

- Planned Capital actions - Assumptions

Schedule Preparation

- Loan and Summary Level Information - Calculate PPNR - Calculate Net Income - Capital Rations, RWA etc.

Reconciliation

- Y9C - Spreadsheets - Population, etc.

Elements of Effective Stress-Test Modeling Frameworks

Integration with Scenarios - PPNR, Credit, Op Risk, and all

models should integrate with the same inputs

- Models should demonstrate ability to differentiate gains/losses well in Base and Adverse scenarios, showing sensitivity to different conditions

- Chosen macro-factors should drive bank’s losses/PPNR

Specificity to the Bank

- Models and data inputs (e.g. housing

prices) should reflect the footprint of the bank and the portfolio composition

- Banks should demonstrate a forward-looking approach and justify that past data is still relevant

- Idiosyncratic Scenario should reflect bank’s specific risks

Conservatism & Challenge - Banks should recognize model risk

and the need to buffer their capital estimates

- Banks should show a plan for continuous improvement for models and awareness of model limits

- Banks should challenge and validate their models regularly

Governance - Model monitoring & controls should be in place - Data quality checks and governance required - Clear integration with ICAAP process

Right Team, Strong Process - Banks need to show ownership of models and results by

the right people - Well-understood, clear process for stress-testing: Becomes

part of Business As Usual

Sample Credit Loss Modeling Framework for CCAR Stress Testing

Portfolio Segment Loan / Pool Data Modeling Approach Key Dependencies Portfolio Segment

C&I - Major Industries - Oil & Gas - Agriculture - etc.

CRE - Construction - Income-

Producing - Land

Retail - Mortgage - HELOC - Credit Cards - Small Business - Other

Macroeconomic and External Data

- National - State-level - MSA-level

- Unemployment - GDP Growth - HPI - T-Bill Rates - etc.

- Property Prices - Land Prices - BBB Bond Spread - Stock Price Volatility

Loan / Pool Data

Loan Level - Ratings - EAD / Balances - Vintage - NAIC Code

Loan Level - Ratings / LTV / DSCR - EAD / Balances - Collateral Type (Retail,

Industrial, etc)

Portfolio Level - Historical charge-offs - Further segmentation

- Vintage/maturity - Legacy acquisition

Modeling Approach

Time Series Analysis - Predict quarterly changes in PD, LGD

using footprint-specific state-level macro-factors (e.g. state-level Unemployment) and prior-period levels, for each industry segment

Time Series Analysis - Predict quarterly changes in LTV and

DSCR using state-level macro-factors and vended property price data

- Defaults trigger charge-offs

Time Series and Static Regression - Predict Charge-offs as function of

macro factors, deposits, prior-period balances, FICO, OLTV, Vintage, Status

- Choice of method depends on data quality and history length

Footprint

States - New York - Connecticut - New Jersey - etc.

Key Dependencies

- Valid PDs, LGDs, or charge-offs by Rating and by risk factor or industry segment

- Rating history or reference data

− Accurate LTVs and vintage

− Reference property price data histories by region and for CLTV

− Balance projections − Charge-off reference

data across credit cycle by risk factor

− Geography − Loan Type

Key Success Factors for Stress-Test Modeling Engagements

What’s Appropriate for the Bank

Alignment with

Business

Knowing the Bank’s

Story

Using Intuitive Key Risk Drivers

Getting Results

Together

Preparing for

Challenges

Knowledge and Tools Transfer

• Do the proposed models fit your business?

• What loss and risk data do you have?

• Internal and external parties should see a model result and be able to understand how it was derived

• Modeling can be complex. Constant and ongoing communication with all interested parties is key (credit, liquidity, rate risk, market risk, operations risks)

• Driving ROI into Process, Concentration Management and Changing Risk Profile

• Full ownership by the bank is the goal, with engagement in the business lines and process going forward

• Model validation, documentation, model use, and the bank team, must be prepared for reviews

• The Models and the narrative in the Capital Methodologies should be consistent and integrated

Overview of Annual Stress Testing Timeline

Covered companies pull financial data to run stress test models. Companies to submit FR Y-14 data

Covered companies submit regulatory report to board on stress tests

Covered companies submit required regulatory report to the Board on mid-cycle stress test

FRB publishes scenarios for upcoming annual cycle

FRB communicates and publishes results of supervisory stress tests Companies disclose the summary results

Companies make required public disclosures on their mid-cycle stress test

Sept 30 Nov 15 Jan 5 Mar 31 Jul 5 Sep 15-30

With consolidated assets greater than $50B

Companies disclose summary of the results of the annual tests

FRB/OCC/FDIC publishes scenarios for upcoming annual cycle

Companies complete stress tests and submit regulatory report to the Board

Companies pull financial data to run stress test models.

Sept 30 Nov 15 Mar 31 Jun 15

With consolidated assets between $10B and $50B Key Differences: Delayed deadline to Mar 31 (against Jan

5), plus one additional year No requirements on mid-cycle stress

test Less detailed disclosure of results for

<$50 billion Significantly more limited reporting forms

(to be devised) Management charged with responsibility

of controls, oversight and documentation Slightly diminished Board

responsibilities; however Board is still charged with reviewing and approving policies, procedures and stress test results Question on formal Capital Plan

submission

Submission Timeline

CCAR Reporting – Monthly, Quarterly and Annual

*Quarterly/Monthly reports subject to materiality threshold ** Quarterly/Monthly worksheets for trading required only for the 6 BHCs subject to trading shock in CCAR 2012

Basel III & DFA

Retail*

Wholesale *

Securities *

Trading ** Operational Risk *

Pre Provision Net Revenue

Regulatory Capital Instruments

FR Y-14Q/M FR Y-14Q / M submissions

required on quarterly or monthly basis

(exposure data such as loan level details)

AFS/HTM Securities

Trading

Counterparty Credit Risk

Operational Risk

Pre Provision Net Revenue

Regulatory Capital Instruments

Income Statement

Balance Sheet

Capital

Retail

Wholesale

Basel III & DFA

FR Y-14A

FR Y-14A submissions required on an annual basis

(Projected balances for scenarios)

• Supporting Documentation • Model Risk Management Policy • Documentation of Risk Measurement Practices

• Documentation of Internal Stress Testing methodology

• Documentation of assumptions and approaches • Validation and Independent Review

Primary Worksheets

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Typical Challenges

Theme Implementation Challenges

Methodology

Ad-hoc execution of CCAR reporting and stress testing with limited focus on sustainment

Credit risk modeling, loss modeling, finance and regulatory reporting (including Basel) are separately documented and not linked

Alignment of CCAR requirements with a structured and flexible capital-planning framework

Inconsistencies in business rules, definitions and assumptions related to key data fields such as PD and Lien information

Data and IT Infrastructure

Multiple or duplicative data sourcing for key components such as Balance Forecasting, Loan loss modeling and credit risk modeling

Significant effort for data sourcing, processing and manipulation to meet CCAR annual reporting and other business/regulatory needs

Lack of a single platform to integrate the components of capital planning/ CCAR

Lack of data availability (historical data, data pertaining to acquired businesses)

Governance

Iterative validation and reconciliation effort requiring intense manual intervention

Lack of active involvement by the Board and senior management in CCAR review and submission

Capital planning/ CCAR is still not an integral part of strategy conversations and is thought of primarily as a regulatory exercise

Identification and definition of roles and interactions specific to capital planning components

Going forward, CCAR is likely to be a core planning element for Finance, Risk and IT functions in BHCs with a focus on achieving business integration and common data infrastructure

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Emerging practices for effective stress testing

Scenarios and integrated

Infrastructure

• PPNR, Credit, Op Risk, and all models should integrate with the same inputs

• Chosen macro-factors should drive bank’s losses/PPNR

• Creation of a single data platform to source, transform, aggregate and report data for CCAR and capital planning requirements

Dedicated focus • Identify key skill and experiences across business, risk, technology and finance required

• Banks need to show ownership of models and results by the right people

• Well-understood, clear process for stress-testing: becomes part of Business As Usual

Governance

• Model monitoring & controls should be in place based on functional awareness of model limits

• Adoption of a prioritization framework to allow focus on models/ issues that are critical in the capital planning process and communicate issues transparently

• Driving consistency in adoption of definitions, business rules and assumptions related to data, especially used for stress testing and projections

Specificity to the Bank

• Models and data inputs (e.g. housing prices) should reflect the footprint of the bank and the portfolio composition

• Idiosyncratic Scenario should reflect bank’s specific risks

• Banks should demonstrate a forward-looking approach and justify that the past data pertaining to Bank is still relevant

Other long term initiatives

• Integrating CCAR into longer term initiatives ( e.g. semi-annual stress testing, impact on ICAAP processes etc.) and aligning regulatory and internal definitions, and timelines

• Integrating CCAR processes into strategy, annual budgeting and planning cycle, performance reporting and internal audit

• Banks should challenge and validate their models regularly and show a plan for continuous improvement for models

Effective Stress test modeling frameworks include the following elements:

Industry Observations • Infrastructure supporting CCAR requirements at Banks are becoming more automated and sustainable, driven in part by

regulatory feedback (MRA / MRIAs)

• Ad-hoc processes and manual adjustments persist, given rule ambiguity / interpretations and evolving regulatory expectations (i.e. Enhanced Prudential Guidelines, Basel III etc.)

• Differences exist in the underlying data and IT systems, processes and governance framework, with varying degrees of centralization (i.e. the extent to which guidance / specificity is provided centrally)

o Scenario projections, capital actions, non-interest expense projections, policy and governance aspects are typically centralized

o Stress test loss projections, data and reconciliation are decentralized to LOB / LOB level credit risk teams

o Basel III RWA projections, loan balance and income projections may follow a mix of centralized and decentralized approaches

• Focus is primarily on BHC (enterprise) level planning

o Increasing focus on standalone DI level planning (i.e. limit structure, risk appetite etc.)

• Identify and achieve easier action steps

o Defining centralized governance frameworks (policies, committee charters) and use of centralized version control software

• Integrate CCAR process with longer term initiatives (internal budgeting, capital planning)

Q&A

Thanks Michael Jacobs, Jr., Ph.D., CFA Deloitte & Touche LLP Audit & Enterprise Risk Services / Government, Risk and Regulatory Services / Business Risk / Financial Services 1633 Broadway, 35th Floor New York, N.Y.. 10281 Office: (212) 436-2956 Home: (212) 369-0025 Cellular: (917) 324-2098 e-mail: mikjacobs@deloitte.com SSRN Author Page: http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=97517 LinkedIn: http://www.linkedin.com/profile/view?id=17630774&trk=tab_pro

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