Another Round of Stress Tests

Global banking these days is so much about building capital bases and passing complicated stress tests.

First there was "Brexit," the U.K.'s referendum leading to a surprising, planned departure from the European Union. Then came the big banks' stress tests, graded by Federal regulators.  In the days after Brexit, there couldn't have been a better time to announce the 2016 results of the annual bank-holding-company stress exams. 

Banks have mountains of new regulation for which they must adhere to between now and 2019. Along the way, they must pass yearly stress tests administered by the Federal Reserve Bank and falling under the more expansive title, "Comprehensive Capital Analysis and Review," referred to more often as "C-CAR."

In the wake of Dodd-Frank legislation, regulators want banks to have sufficient amounts of capital to withstand shocks, losses and surprises during the ordinary course of business and to endure the worst possible scenarios, those that lead to unexpected losses.  The capital guidelines are detailed and complex. The formulas used to calculate precisely the amounts of capital to act as worst-case cushions are as complicated as a graduate-school statistics course. They aim to compute expected and unexpected losses.  They consider such factors and variables as 99-percent confidence levels (for worst-case scenarios), correlation, loan default probabilities, concentration, market volatility, market sensitivity and market shortfalls. 

But even after data accumulation and calculations and after banks report they have far more than the minimum amounts, U.S. regulators require the stress tests. They want to cover all bases. They want to make sure they haven't overlooked other negative influences--like a Brexit-type event, oil prices deep-diving toward $20/barrel, or a global recession appearing from nowhere.

So the exercise is this: 

Banks first address Basel III requirements.  They routinely tally up all their risks (credit, market, operational, contingent, and off-balance-sheet), perform the calculations to assure regulators they have enough capital (the sum of equity and some forms of long-term debt) and assert their capital totals will tolerate massive losses, including that arise about once a century (like those from the period of 2008-09). 

The risk tally sums up to a total of risk-weighted assets (RWA). A bank's loan to, say, investment-grade companies like Home Depot or John Deere is "risk-weighted" downward, compared to the bank's loan to a struggling, non-investment-grade borrower like, say, Sears, Valeant, or now-bankrupt Sun Edison. The minimum capital requirements (Common Equity, Tier 1, Tier 2, Total Capital), tied to RWA, are stipulated by Basel III rules. 

And then, oh, by the way, after all those calculations, come the stress tests.  Regulators require yet another vigorous shake-up to balance sheets, bank operations and the financial system to see if banks can still survive with ample amounts of capital.

Hence, the latest stress tests.

Every U.S. bank passed this time, although one bank (Morgan Stanley) was put on what might be called regulatory probation, a conditional watch list. (Two subsidiaries of foreign banks ran into trouble:  Deutsche Bank and Santander.)  Citi, which fumbled the test the last time, was determined to be a leader of the pack this time.  Its stress test showed how the worst of all worst-case scenarios could lead to the bank suffering over $34 billion in losses over an 18-24-month period. Yet it proved (and regulators agreed) it would still have ample capital resources to remain sound and viable--not just barely solvent. Its equity "cushion" would still exceed $150 billion. (Most of those losses would come from loan losses on its consumer and corporate-lending portfolio.)

In the latest test, regulators presented the following scenario:

1) U.S. unemployment rates would rise above 10%. That would have impact on consumer loan and residential-mortgage portfolios and would have eventual impact on corporate borrowers that depend on thriving retail markets.

2) The U.S. dollar appreciates substantially. That would have impact on global corporate loans and U.S. borrowers with substantial exports. It would affect U.S. banks with big balance sheets abroad. (Some would argue that banks' currency-trading units, which thrive on volatility, might have income upswings to offset other losses.)

3)  U.S. Treasury securities will trade with negative yields (as many Euro-issues have done in the past year). That would have a detrimental impact on bank earnings (net-interest margins) and might encourage banks to take out-size risks to recoup negative earnings on Treasuries they may have held for liquidity purposes.

4) "Flight-to-safety" capital flows would occur and would like result in rocky, strangely behaving markets.  That would result in financial institutions dumping riskier assets for safe-haven instruments (sovereign debt, high-rated bonds, or even U.S. Treasuries with negative yields), likely causing a collapse in a range of assets (equities, commodities, lower-rated corporate bonds, mortgages, etc.). This would replicate 1998's Asian and Russian crisis, when flights to safety led to a sudden widening of bond spreads, as investors dumped mortgage bonds and any asset that smelled risk for U.S. Treasuries.

Regulators this time hadn't really identified a Brexit, didn't predict it, or at least didn't specify such a case in the detail they described for scenario possibilities. But stress tests are supposed to capture the risks of Brexit-like occurrences. 

The tests aren't conducted as easily as they appear.  While it is straightforward to describe a stress scenario, all bank activities, assets, loans, trading positions, liabilities, and legal entities are subject to these downside cases. All results must be quantified with reasonable precision.

Out spills a grand total of possible losses over a defined time horizon. The losses are subtracted from current capital totals. Regulators then access whether the bank, after all, still has sufficient loss-absorbing capital to meet Basel III requirements.

Banks that pass can exhale. The exercises, however, don't go onto a shelf or get buried in electronic files in a compliance department.  Banks gear up and prepare for the next test or take measures to ensure on an ongoing basis they can pass the test any time its administered with a different, but similarly outrageous, but realistic list of extreme market characteristics.

Some big banks this year proved to have so much ample capital they proved to the Federal Reserve they could pay higher dividends and resume stock-repurchase programs. They proceed with such shareholder rewards, confident they will continue to generate earnings quarter after quarter.

Ever since Dodd-Frank and Basel II and III rolled onto the financial scene, banks know well they must continue to keep those capital bases swelling and growing. And they want to the headlines that come with having fallen short of expected capital requirements or having failed a stress test.

Tracy Williams

See also:

CFN:  Basel III Becoming Real, 2013
CFN:  JPMorgan's Refined Regulatory Strategy, 2014
CFN:  Big Banks:  The Dreadful Downgrades, 2012
CFN:  Bank ROE's: Stuck at 10%, 2015
CFN:  Banks and Living , 2016
CFN:  Banks and Their Energy Loans, 2016
CFN: When Does a Bank Have Enough Capital? 2015