Daniel K Tarullo: Developing tools for dynamic capital supervision
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Federal Reserve Bank of Chicago Annual Risk Conference, Chicago, Illinois
(via videoconference), 10 April 2012.
* * *
The importance of robust capital requirements for financial stability and the serious
shortcomings of the pre-crisis capital regulatory regime have been well documented. In the
last few years, domestic and international initiatives have strengthened standards for the
quantity and quality of capital held by banking organizations. Implementation of these new
standards should significantly increase the safety and soundness of the financial system.
But there are at least four reasons why simple compliance with the stricter standards will not
achieve this goal. First, as has long been recognized, a capital ratio - even a much higher
one - is essentially a snapshot of a bank's balance sheet and, thus, often a lagging indicator
of the bank's actual condition. Second, the ability of a bank to remain a viable financial
intermediary in times of stress depends not only on the losses likely to affect the value of
current assets, but also the impact on revenues and, thus, the capacity to replenish capital
during the stress period. Third, if capital requirements are set solely with reference to more
ordinary economic circumstances, they will not capture the potential impact of a shock to the
value of widely held assets to the financial system as a whole. Fourth, the capacity of both
bank management and regulators to understand a firm's capital position depends on its
having good information and quantitative risk-management systems.
Thus, stronger capital standards must be complemented with supervisory tools that
incorporate dynamic, macroprudential elements. Two important such tools that have been
adopted by the Federal Reserve since the onset of the financial crisis are stress testing and
firm-specific capital planning. Since we have just completed a second annual exercise using
both supervisory tools, I thought this risk conference would be a good occasion for reviewing
the rationale and features of these tools, describing the recent results, and identifying some
issues we will be considering as we continue to develop these tools in the future.
Tools for dynamic capital supervision
The potential utility of comprehensive stress testing had been much discussed among
academics, analysts, and regulators in the years preceding the financial crisis, but it was only
during the crisis that this tool was used across large firms at the same time. In February
2009, the federal banking agencies - led by the Federal Reserve - created a stress test and
required the nation's 19 largest bank holding companies to apply it as part of our Supervisory
Capital Assessment Program (SCAP). The test involved two scenarios - one based on the
consensus forecast of professional forecasters, and the other based on a severe, but
plausible, economic situation - with specified macroeconomic variables such as GDP
growth, employment, and house prices. Each participating institution was asked to supply, in
a standardized format, detailed information on portfolio risk factors and revenue drivers that
supervisors could use to estimate losses and revenues over a two-year period. These data
allowed supervisors to make consistent estimates across all 19 firms.
The immediate motivation for the 2009 stress test was to determine how much additional
capital a bank holding company would need to ensure that it would remain a viable financial
intermediary even in the adverse scenario. The Treasury Department stood ready to provide
capital to any bank that could not raise the required amount from private sources. But the
Federal Reserve's decision to disclose the results of the test on a firm-specific basis served a
second purpose - to provide investors, and markets more generally, with information that
would help them form their own judgments on the condition of U.S. banking institutions. This
decision proved to be an important step in establishing market and public confidence that the
U.S. financial system would weather the crisis.
Though conceived and developed in the midst of the financial crisis, SCAP will be
remembered as a watershed for supervisory policies applicable to large institutions.
Congress drew on the lessons of the 2009 exercise by including a requirement for stress
testing in the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank Act). But well before Congress passed the Dodd-Frank Act, the SCAP
experience had already profoundly affected attitudes toward supervision within the Federal
Reserve. It demonstrated in practice, not just in theory, the value of a simultaneous,
forwardlooking projection of potential losses and revenue effects based on each bank's own portfolio
and circumstances. The forward-looking feature overcame the limitations of static capital
ratios. The simultaneity, along with stress test features such as an assumed instantaneous
market shock, introduced a critical macroprudential dimension that offered insights into the
condition of the entire financial system, including whether banks were sufficiently resilient to
continue to provide their critical intermediation functions even under such adverse conditions.
Regular and rigorous stress testing thus provides regulators with knowledge that can be
applied to both microprudential and macroprudential supervision efforts. Disclosure of the
methodology and firm-specific results of our stress testing has additional regulatory benefits.
First, the release of details about assumptions, methods, and conclusions exposes the
supervisory approach to greater outside scrutiny and discussion. Such discussions will
almost surely help us improve our assumptions and methodology over time. Second,
because bank portfolios are difficult to value without a great deal of detailed information, the
test results should be very useful to investors in and counterparties of the largest institutions.
The market discipline promoted by means such as resolution mechanisms will be most
effective if market participants have adequate information with which to make informed
judgments about the banks.
But stress testing is no more a panacea for the supervision of large financial institutions than
capital requirements themselves, or any other regulatory device. By design, the stress tests
to date have not covered other sources of stress, such as funding and interest rate risks,
which are the subjects of other supervisory exercises. But just as strengthened capital
requirements remain at the center of a better financial regulatory system, so stress testing is
now recognized as a critical, forward-looking tool for ensuring that minimum capital
requirements can be maintained. Indeed, stress testing has already come to epitomize the
horizontal, interdisciplinary approach to supervising our largest bank holding companies that
the Federal Reserve System has instituted over the past few years.
Firm-specific capital planning has also become an important supervisory tool. In November
2011, the Federal Reserve issued a new regulation requiring large banking organizations to
submit an annual capital plan.1 This tool serves multiple purposes. First, it provides a regular,
structured, and comparative way to promote and assess the capacity of large bank holding
companies to understand and manage their capital positions, with particular emphasis on
risk-measurement practices. Second, it provides supervisors with an opportunity to evaluate
any capital distribution plans against the backdrop of the firm's overall capital position, a
matter of considerable importance given the significant distributions that some firms made in
2007 even as the financial crisis gathered momentum. Third, at least for the next few years, it
will provide a regular assessment of whether large holding companies will readily and
comfortably meet the new capital requirements related to various Basel agreements as they
take effect in the United States.
A stress test is a critical part of the annual capital review. But, as these different purposes
indicate, the capital review is about more than using a stress test to determine whether a
firm's capital distribution plans are consistent with remaining a viable financial intermediary
even in an adverse scenario. As indicated during our capital reviews in both 2011 and 2012,
the Federal Reserve may object to a capital plan because of significant deficiencies in the
capital planning process, as well as because one or more relevant capital ratios would fall
below required levels under the assumptions of stress and planned capital distributions.
Likewise, the stress test is relevant not only for its role in the capital planning process. As
noted earlier, it also serves other important purposes, not least of which is increased
transparency of both bank holding company balance sheets and the supervisory process of
the Federal Reserve.
Results of the 2012 stress test and capital review
The stress test that the Federal Reserve developed in the fall of 2011 and administered over
the succeeding months was based on a quite adverse scenario. It hypothesized a deep
recession in the United States, with GDP contracting sharply, unemployment reaching a
peak of more than 13 percent, equity prices falling by half, and house prices declining by an
additional 20 percent from their 2011 levels. In addition, given the potential for financial
stress in Europe, the scenario included a global recession and a global financial market
shock. The latter, applied to the trading, derivatives, and private equity positions of the six
firms with the highest volumes of trading, included a dramatic widening of credit default
spreads for both European sovereigns and financial institutions, as well as sharp increases in
spreads for European sovereign bonds.
When we announced the scenario in November, a number of observers questioned whether
a scenario of this severity was realistic. In this regard, it is important to reemphasize that the
stress scenario is not a forecast of what will happen. It reflects, instead, an unlikely but not
implausible outcome in which the U.S. economy experiences a serious recession
simultaneously with a significant contraction of global economic activity and a global financial
shock. Thus, the assumed increase in unemployment is similar to that experienced in the
three deep post-World War II recessions. It is because current unemployment stands so
much higher today than it did at the outset of those recessions that it is assumed to rise to a
postwar high.
More fundamentally, the severity of the recession reflects two considerations. First, as I have
already suggested, a core rationale for stress testing is the macroprudential goal of ensuring
that the nation's financial system could continue to operate even in the face of severely
adverse developments. It is precisely an outcome fairly far out on the tail at which a stress
test should be directed. A more probable scenario, with a milder downturn, would not serve
that purpose. Second, presumably reflecting this logic, the Dodd-Frank Act requires that we
include a "severely adverse" scenario. Accordingly, as we fully implement the Dodd-Frank
requirement beginning next year, this level of severity will in any case be required by law.
As one might expect from the severity of the adverse scenario, the losses projected by our
models for the 19 firms were quite high. Total losses amounted to about $650 billion, of
which $535 billion was due directly to declines in balance sheet asset values. The remaining
$115 billion was accounted for by additional items run directly through net revenue
estimates, such as expenses from mortgage putbacks. The portfolio losses would be very
high by historical standards. For example, the $340 billion in loan losses included in the total
loss figure translates into a loss rate of about 7.2 percent, which compares to about a
5.4 percent loss rate in the peak eight quarters of losses during the financial crisis and is a
higher rate than has been experienced at any point in the last century except during the
Great Depression. Similarly, pre-provision net revenue was projected to be equal to only
about 2.5 percent of average assets, an historically low rate that compares to about
3.5 percent during the nine-quarter period from the fourth quarter of 2007 through the fourth
quarter of 2009 that spanned the financial crisis.
Notwithstanding the stringency of the stress test, only four of the nineteen firms fell below the
5 percent Tier 1 common ratio standard, or one of the other applicable ratios, even assuming
that all proposed capital actions went forward during the stress period. In passing, I might
observe that we would expect that firms would, in fact, pare their distributions in the face of a
severely deteriorating operating environment, but the fact that some firms failed to do so in
2007 and 2008 has led our supervisors to make the conservative assumption that
distributions would continue. If proposed future capital distributions are not assumed - that
is, if the approach in the 2009 SCAP is taken - only one firm falls below the required
post-stress minimum capital ratios.
Indeed, a comparison with the original 2009 stress test shows the degree to which the
19 firms have improved their capital positions. The actual aggregate Tier 1 common ratio of
the 19 firms at the end of the third quarter of 2011 (the beginning of the stress period) was
about 10.1 percent, nearly double the 5.3 percent aggregate ratio for the firms at the end of
2008 (the start of the stress period for SCAP). Moreover, at 6.3 percent, the post-stress
aggregate ratio under the 2012 test would be higher than that actual aggregate capital ratio
at the end of 2008, even assuming all proposed capital actions go forward during the stress
period.
As to qualitative conclusions from this year's Comprehensive Capital Analysis and Review
(CCAR), most of the 19 bank holding companies have made considerable progress in their
internal capital planning processes. However, there appears to be room for improvement at
virtually every firm, and at some firms the amount of work needed is still significant.2 This will
remain a major focus of supervisory efforts, in next year's capital review, and more generally.
The 2012 experience in retrospect
The 2012 exercise extended our supervisory emphasis on forward-looking, data-driven,
horizontal assessments of the largest bank holding companies. It built upon, and
incorporated, lessons learned from prior exercises. But these supervisory tools are still
relatively new. Just as capital planning and internal stress testing capacities could be
improved at every firm, so we intend to consider both substantive and procedural
improvements in our use of these tools. To this end, over the coming months we will be
consulting extensively with academics, other analysts, and the banks themselves.
Substantively, the Federal Reserve will be focusing on potential refinements to supervisory
models, such as modifying them to use more granular data. We will continue to pay
considerable attention to model validation. Among other things, we are forming an advisory
group of academics and other experts to advise our internal model-validation team on an
ongoing basis. Then, later in the year, we intend to convene a modeling symposium to bring
a broader array of voices into the discussion.
We are, of course, mindful of the statements by some of the 19 participating bank holding
companies that certain loss rates produced by the Federal Reserve's model for the 2012
stress test significantly exceeded their own estimates. We may gain greater insight into the
source of these differences as we proceed with the review of our modeling. However, our
experience during the stress test has already suggested some possible reasons. First, not
surprisingly, the supervisory perspective on stress test modeling tends to be somewhat more
conservatively inclined than that of the firms. Second, Federal Reserve modeling generally
avoids the assumption that loss experience during a period of high stress can be
extrapolated from experience in more normal times, whereas at least some firm modeling
uses roll rates and other such extrapolations that may not be as useful for measuring losses
in tail events. A third, and related point, is that for some loan types the Federal Reserve
model incorporates nonlinear effects of the macroeconomic scenario. For example, a
20 percent decline in national house prices would mean that prices would decline
substantially more in some markets and less in others, and losses in areas where house
prices decline more would be disproportionately greater than losses in areas where house
prices decline by less. The result would be higher overall losses than if prices had declined
by a uniform 20 percent everywhere. Fourth, supervisors had the advantage of seeing the
modeling practices of all 19 of the firms and were able in some instances to identify outliers
in terms of assumptions and practices.
Our disclosures - both of our methodology and of the results - seem to have struck about
the right balance between providing useful information to investors, counterparties, and the
public, on the one hand, and protecting proprietary information whose release might result in
competitive harm to firms, on the other. However, as with all aspects of the stress test and
CCAR, we welcome any suggestions for improvement here as well.
As to procedure, we have already decided on several changes for next year. First, the timing
of the CCAR will change, so that the decisions on objection or non-objection will apply to
capital actions beginning in the second quarter of 2013. That is a shift from the first two
CCARs, in which the supervisory responses covered first quarter capital plans, but those
responses were not delivered until late in that quarter. Second, now that the regulatory
reporting mechanisms for data collection are in place, we will be able to begin the analysis
earlier, thereby providing more time to both firms and supervisors to run the stress tests.
Incidentally, because these reports will be filed quarterly, our supervisors will be able to
monitor more effectively how firms are performing relative to their projected baselines. This,
in turn, will enable us to require resubmissions of capital plans in a more timely way, should
conditions change materially at an individual firm or more broadly in the industry.
One issue that we will be considering at some length is the nature of communications
between supervisors and firms during the duration of the stress test and CCAR. Some of the
practical concerns about communication can be fairly easily addressed, such as by
continuing to improve the timeliness of answering technical questions and generally having
more coordinated communication with the firms throughout the process.
Other concerns will require more extensive thought. I think it fair to say, for example, that
many firms were frustrated by the limitations on how much supervisors would communicate
about modeling assumptions and other information relevant to capital planning decisions.
Here, there is some tension between the desirability of providing more information to firms
and the importance of not turning capital planning into a mechanical compliance exercise, in
which firms simply run the Federal Reserve model, instead of developing and enhancing
their own risk-management and capital planning capacities. We do not want to encourage a
world in which everyone simply applies the same risk-management model, rather than
engages in the important and multidimensional process of evaluating and modeling risk. But
there should be ways to provide some further explanation of our modeling approach without
leading to this outcome, particularly in the aftermath - rather than in the middle - of the
supervisory exercise itself.
As a first step along these lines, we hope the symposium and other channels for discussing
good modeling practices will reduce the "black box" feeling of some of the firms. Of course,
good modeling - whether at a firm or at the Federal Reserve - should be adapted to take
advantage of improved data and advances in risk management. It would not be desirable to
fix upon a model and continue to use it even as it becomes stale and, thus, potentially
misleading.
In this regard, I note that the Dodd-Frank stress testing regime that we will implement
requires that the bank holding companies themselves disclose the results of their own stress
tests. This will be a valuable augmentation of the transparency around stress testing,
providing markets and stakeholders with more information about the risk-management
practices of bank holding companies and creating points of comparison with the Federal
Reserve's stress testing. More generally, there will be a good deal of continuity as we
implement the stress testing requirements of the Dodd-Frank Act. But the statute requires
some additional elements, such as using three, rather than two, scenarios. We are currently
accepting public comment on our proposed regulation implementing this part of Dodd-Frank.
Conclusion
Stress testing and regular capital review exercises have already become key components of
our supervisory program for large bank holding companies. Indeed, as I suggested earlier,
they are critical for ensuring that the increased resilience of the financial system envisioned
in the post-crisis strengthening of capital requirements is realized. Furthermore, just as these
supervisory instruments aim for dynamic assessment of capital needs, so they will remain
dynamic, adapting in response to our experience, economic and financial conditions, and
advancements in risk measurement.
Having offered an encomium to these tools, let me end by making clear that a
one-size-fitsall approach is no more appropriate here than in most other areas of prudential supervision.
While forward-looking assessment is important for capital planning in all banking
organizations, the specific, sophisticated character of the kind of stress test we ran this year
is surely neither necessary nor suitable for smaller banking organizations. For firms with
more than $10 billion but less than $50 billion in total consolidated assets, the nature of any
stress testing requirements will be quite different from that used in the CCAR. For banks with
assets of $10 billion or less, I would not expect any kind of supervisory stress testing
requirements.