Bank Regulatory Capital Requirements

US Capital Planning and Stress Tests

Supervisory stress testing by banking regulators gained prominence during the banking crisis of 2007–2009. In particular, in 2009, banking supervisors conducted the Supervisory Capital Assessment Program (SCAP) to assess the largest bank holding companies' capital positions. SCAP presented two hypothetical macroeconomic scenarios, including one that was more adverse than what was expected for the US economy, for BHCs to use in estimating the impact on capital. The Federal Reserve publicly reported that 10 of the 19 BHCs that were included in SCAP did not meet the capital adequacy requirements under the adverse macroeconomic scenario. As a result, these BHCs were collectively required to add $185 billion in capital by the end of 2010.

Section 165(i) of the Dodd-Frank Act mandated an annual assessment by the Federal Reserve of BHCs with $50 billion or more in total consolidated assets, as well as smaller BHCs and nonbank financial institutions that are regulated by the Federal Reserve. This annual assessment includes two related programs: the Comprehensive Capital Analysis and Review (CCAR) and supervisory stress testing (DFAST). These annual stress tests look at whether the BHCs have effective capital adequacy processes and sufficient capital to absorb losses during stressful conditions, while meeting obligations to creditors and counterparties and continuing to serve as credit intermediaries.

In late 2010, the Federal Reserve – acting in part in response to the statute – initiated the CCAR exercise. As part of the exercise, the Federal Reserve evaluates institutions' capital adequacy, their internal capital adequacy assessment processes, and their individual plans to make capital distributions, such as dividend payments or stock repurchases. More specifically, CCAR specifies four mandatory elements of a capital plan: (1) an assessment of the expected uses and sources of capital over the planning horizon that reflects the BHC's size, complexity, risk profile, and scope of operations, assuming both expected and stressful conditions; (2) a detailed description of the BHC's process for assessing capital adequacy; (3) the BHC's capital policy; and, (4) a discussion of any baseline changes to the BHC's business plan that are likely to have a material impact on the BHC's capital adequacy or liquidity.

The Federal Reserve has conducted CCAR annually since its inception in 2010 for the largest BHCs. For the CCAR 2015 exercise, the Federal Reserve issued instructions on 17 October 2014, and received capital plans from 31 BHCs on 5 January 2015. Table 7 shows the banks participating in CCAR in 2015 as well as the required capital ratios. The 31 BHCs that are part of this CCAR held more than 80 percent of the total assets of all US BHCs, or $14 trillion as of the fourth quarter of 2014. The Federal Reserve reported that, in 2015, for the first time, no participating bank fell below the quantitative benchmarks that must be met in CCAR after some BHCs made onetime downward adjustments to their planned capital distributions or redemptions. However, the Federal Reserve did object to Santander's CCAR 2015 capital plan on qualitative grounds because of widespread and critical deficiencies across the BHC's capital planning processes. The Federal Reserve also objected on qualitative grounds to the capital plan of Deutsche Bank Trust Corporation because of numerous and significant deficiencies across its risk-identification, measurement, and aggregation processes; approaches to loss and revenue projection; and, internal controls.

Table 7.Comprehensive Capital Analysis and Review (CCAR) 2015 Bank Holding Companies (BHCs) and Applicable Minimum Capital Ratios.

DFAST – a complementary exercise to CCAR – is a forward-looking quantitative evaluation of the effect of stressful economic and financial market conditions on a bank's capital. In 2012, the Federal Reserve finalized the rules that implement the stress test requirements under the Dodd-Frank Act. All BHCs and IDIs with $10 billion or more in total consolidated assets are required to conduct an annual company-run stress test. BHCs with assets greater than $50 billion must conduct semiannual company-run stress tests and they also are subject to stress tests conducted by the Federal Reserve. The company-run tests must include three scenarios, and the institutions must publish a summary of the results. The estimated losses resulting from these tests are then subtracted from a bank's capital to determine the financial buffer that a bank has to insulate itself from shocks and losses. A bank effectively fails the tests if its capital falls below a required minimum level after the theoretical losses.

While DFAST is complementary to CCAR, both efforts are distinct testing exercises that rely on similar processes, data, supervisory exercises, and requirements. However, there are important differences between the two exercises. For CCAR, the Federal Reserve uses BHCs' planned capital actions and assesses whether a BHC would be capable of meeting supervisory expectations for minimum capital levels, even if stressful conditions emerged and the BHC did not reduce planned capital distributions. By contrast, for DFAST, the Federal Reserve uses a standardized set of assumptions that are specified in the Dodd-Frank Act stress test rules. DFAST is therefore far less detailed and less tailored to a specific BHC.

The requirements, expectations, and activities relating to DFAST and CCAR do not apply to any banking organizations with assets of $10 billion or less. In particular, community banks are not required or expected to conduct the enterprise-wide stress tests that are required of larger organizations under the capital plan rule, the rules implementing the Dodd-Frank Act stress testing requirements, or the procedures described in the stress testing guidance for organizations with more than $10 billion in total consolidated assets. As noted, BHCs with $10 to $50 billion in assets are only subject to firm-run stress tests for DFAST.

Stress testing requirements are a risk-assessment supervisory tool. The goal of stress tests conducted under the Dodd-Frank Act is to provide forward-looking information to supervisors to assist in their overall assessments of a bank's capital adequacy and to aid in identifying downside risks and the potential impact of adverse outcomes on the covered bank. Further, these stress tests support ongoing improvement in a bank's internal assessments of capital adequacy and overall capital planning. Yet, according to the Office of Inspector General of the Federal Reserve, "the Federal Reverse's Model Validation Unit does not currently conduct a formal assessment of the expertise required to validate each model or maintain an inventory to track the skills and expertise of reviewers". Furthermore, as evidence of additional problems at the Federal Reserve, "[T]he governance review findings include… a shortcoming in policies and procedures, insufficient model testing, insufficient planning and procedures to address the risks posed by potential key-personnel departures, and incomplete structures and information flows to ensure proper oversight of model risk management". These and other types of problems, such as a lack of transparency and forced homogeneity, call the usefulness of DFAST into question.

On the positive side, CCAR and DFAST may induce banks to have more capital than they would if they were subject only to the traditional capital requirements. As a result of the stress tests and other post-crisis measures, banks may have become less susceptible to financial distress, but at the same time, to the extent that such measures have associated compliance costs, they may have affected lending decisions, especially to smaller firms.