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Tuesday, September 2, 2014

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Assessing the Strength of the Nation's Banks

In early 2009, the Federal Reserve Bank of Philadelphia played an integral role in conducting a comprehensive banking stress test to assess the strength of the country's largest banking organizations and to determine how well the financial system was prepared to survive a challenging economic downturn.

Led by the Federal Reserve Board of Governors, this exhaustive effort enlisted more than 150 examiners, economists, and analysts from the Fed and other federal bank supervisors to conduct the stress test, officially named the Supervisory Capital Assessment Program (SCAP).

The 19 bank holding companies with assets of more than $100 billion were required to participate in this exercise. Collectively, these complex companies hold two-thirds of the assets and more than half of the loans nationwide.

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SCAP's purpose was to measure how much additional capital — if any — each institution would need to withstand potential losses under more adverse economic conditions. SCAP employed both a baseline economic scenario and a hypothetically more adverse scenario in its assessment.

In fact, the Philadelphia Fed's Research Department had a role in helping design the severe economic scenarios for SCAP. Working with the Fed's Board of Governors, Philadelphia used its quarterly Survey of Professional Forecasters to elicit information about measures of uncertainty in the forecasters' projections. It was important to create a hypothetical "what if" forecast, which called for economic conditions — growth, unemployment, and the housing market — to be severe but plausible.

"The stress test was important in assuring the public that banks would remain viable if economic conditions worsened. Public confidence plays such a vital role in the banking system, and this test was critical to helping calm the markets and restore public confidence," said Michael E. Collins, executive vice president and lending officer in the Supervision, Regulation and Credit Department (SRC).

Testing Process

Stress testing isn't new to the banking industry. A bank's management continually conducts stress tests based on its asset size, portfolio composition, and risk characteristics to help establish effective internal risk systems. The testing process should be integrated into the bank's risk culture, yet remain flexible to adapt to new and emerging issues. Its results should reveal the bank's strengths and weaknesses in favorable and unfavorable economic conditions.

Although SCAP shares similarities with a bank's internal stress test, this financial exam was unique.

"The scope and scale were unprecedented. The rigorous review of loan portfolios, investment securities, trading positions, and off-balance-sheet commitments provided a window into our largest institutions, which are key players in our financial system. The results will be important in assessing future capital adequacy," Collins said.

SRC's Role

The Philadelphia Fed's retail credit risk function within SRC dedicated six specialists to the SCAP tests. Todd Vermilyea, vice president of retail risk and bank surveillance in SRC, oversaw Philadelphia's efforts and helped manage multiple challenges.

Assessing the TruthWe had to overcome significant data, logistic, and deadline challenges to produce a comprehensive and consistent set of results," Vermilyea said of his team.

The group — Vermilyea, Jose J. Canals-Cerda, Ali Cannoni, Larry Cordell, Eddy Hsiao, and Andrew Kish — each worked on different teams and collaborated with colleagues inside and outside the Federal Reserve. They worked in tandem with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation.

Challenges in Testing

In what may seem an unusual approach, experienced examiners and staff were assigned to evaluate firms for which they possessed limited first-hand knowledge to make certain that outcomes were unbiased. In this regard, Canals-Cerda and Cordell were assigned to analyze losses on retail credit products for several firms.

"Independent views, ranging from economists' loan loss models to examiners' detailed conversations with bank managers, were a hallmark of this financial examination," Vermilyea said. These outside experts worked closely with on-site examiners, who had detailed knowledge of each of the institutions. Collaboration among these groups was essential given the very tight time frame.

As they pored over hundreds of pages of bank reports, supervisors worked together in identifying weaknesses in models, obtaining missing information, and recalculating over-optimistic assumptions. Their objective was to produce consistent results, a difficult task given the differences in the way the institutions reported and presented their data.

The Philadelphia Fed took a lead role in analyzing off-balance-sheet positions. Weaknesses in accounting for off-balance-sheet vehicles were being addressed in a new set of Financial Accounting Standards set to take effect in 2010. Given that the stress test forecast losses through 2010, the analysis of off-balance-sheet exposures had to reflect both the institutions' overall exposures and the impact of these accounting changes. Andy Kish, who was on assignment at the Federal Reserve Board of Governors during the stress test, designed a model to estimate these off-balance-sheet losses. Kish worked closely with accounting expert Hsiao to ensure that the model was consistent with the proposed changes in accounting rules.

Kish also assisted in the SCAP evaluation of credit card losses. Credit card loans are concentrated in the country's biggest banks and historically have much higher loss rates, carrying more risk than auto or mortgage loans, he said.

"It was an invigorating time and meaningful work to understand the issues during a low point in the financial market. The stress test was a key turning point in the financial crisis, and the test's outcome gave the market confidence," Kish said.

Ali Cannoni, who joined the Bank's retail risk function about three weeks before the stress test began, was enthusiastic about her role. She previously spent almost two years in the Bank's Financial Statistics Department, which honed her skills in reviewing bank data and graphical analysis. And now she was tasked with reviewing larger and more complex institutions.

"The banks' data and the materials they submitted tell a story," Cannoni explained. It was her job to keep track of the stories through every change to multiple spreadsheets representing hundreds of billions of dollars in off-balance-sheet positions.

Test Results

What did this stringent stress test reveal about the banking industry? The results showed that 10 of the 19 institutions required $185 billion to ensure adequate capital cushions to absorb losses if the economy were to deteriorate as the adverse hypothetical case suggested. They had 30 days to develop a plan to raise capital (to be approved by supervisors) and were required to implement their plans in six months.

When regulators released the results on May 7, 2009, they also reported that the 10 banks needing capital had already either raised or were contractually committed to raising $110 billion in capital, leaving $75 billion to be raised. By the November 2009 deadline, the 10 banks had increased their Tier 1 common equity by more than $77 billion. They accomplished this primarily by issuing new common equity, converting existing preferred equity to common equity, and selling businesses or portfolios of assets.

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Future Implications

The banks' actions to shore up their capital positions helped reassure the financial markets. In March, Fed Governor Daniel K. Tarullo discussed the lessons learned from last year's stress test and how it fostered this reassurance. Most market participants accepted the test as credible, he said, adding that the result bolstered confidence because it helped the market understand that our largest banks could withstand severe economic conditions during a very uncertain time.

The stress test has also demonstrated the benefits of using benchmarking to common standards, highlighted the value in collaborative efforts, and provided a detailed view of the health of the banking system.

"The Federal Reserve System has indicated it will incorporate ideas from the stress test's cross-firm approach but will also retain the traditional supervisory exam process, which relies on examiners' insights at the firm level," Collins said. "Stress testing has evolved from focusing on narrow business lines to encompassing the broader business strategies of the institution," he added. Collins said that he has seen the value of employing a more holistic approach to the supervisory process for the institutions in Philadelphia's District.

What did Philadelphia learn from its role in the stress test? "We have integrated the knowledge and wisdom gained from the stress test into our supervisory approach. Our experience also reinforced that we must continue investing in talented staff with the skills to monitor and mitigate the complex issues in our banking system," Collins said.


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