Troubled Asset Relief Program: Bank Stress Test Offers Lessons as Regulators Take Further Actions to Strengthen Supervisory Oversight
Published: 2010-09-29T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The Supervisory Capital Assessment Program (SCAP) was established under the Capital Assistance Program (CAP)--a component of the Troubled Asset Relief Program (TARP)--to assess whether the 19 largest U.S. bank holding companies (BHC) had enough capital to withstand a severe economic downturn. Led by the Board of Governors of the Federal Reserve System (Federal Reserve), federal bank regulators conducted a stress test to determine if these banks needed to raise additional capital, either privately or through CAP. This report (1) describes the SCAP process and participants' views of the process, (2) assesses SCAP's goals and results and BHCs' performance, and (3) identifies how regulators and the BHCs are applying lessons learned from SCAP. To do this work, GAO reviewed SCAP documents, analyzed financial data, and interviewed regulatory, industry, and BHC officials.
section_title: What GAO Found
paragraphs: The SCAP process appeared to have been mostly successful in promoting coordination, transparency, and capital adequacy. The process utilized an organizational structure that facilitated coordination and communication among regulatory staff from multiple disciplines and organizations and with the BHCs. Because SCAP was designed to help restore confidence in the banking industry, regulators took unusual steps to increase transparency by releasing details of their methodology and sensitive BHC-specific results. However, several participants criticized aspects of the SCAP process. For example, some supervisory and bank industry officials stated that the Federal Reserve was not transparent about the linkages between some of the test's assumptions and results. But most of the participants in SCAP agreed that despite these views, coordination and communication were effective and could serve as a model for future supervisory efforts. According to regulators, the process resulted in a methodology that yielded credible results. By design, the process helped to ensure that BHCs would be capitalized for a potentially more severe downturn in economic conditions from 2009 through 2010. SCAP largely met its goals of increasing the level and quality of capital held by the 19 largest U.S. BHCs and, more broadly, strengthening market confidence in the banking system. The stress test identified 9 BHCs that met the capital requirements under the more adverse scenario and 10 that needed to raise additional capital. Nine of the 10 BHCs were able to raise capital in the private market, with the exception of GMAC LLC, which received additional capital from the U.S. Department of the Treasury (Treasury). The resulting capital adequacy of the 19 BHCs has generally exceeded SCAP's requirements, and two-thirds of the BHCs have either fully repaid or begun to repay their TARP investments. Officials from the BHCs, credit rating agencies, and federal banking agencies indicated that the Federal Reserve's public release of the stress test methodology and results in the spring of 2009 helped strengthen market confidence. During the first year of SCAP (2009), overall actual losses for these 19 BHCs have generally been below GAO's 1-year pro rata loss estimates under the more adverse economic scenario. Collectively, the BHCs experienced gains in their securities and trading and counterparty portfolios. However, some BHCs exceeded the GAO 1-year pro rata estimated 2009 losses in certain areas, such as consumer and commercial lending. Most notably, in 2009, GMAC LLC exceeded the loss estimates in multiple categories for the full 2-year SCAP period. More losses in the residential and commercial real estate markets and further deterioration in economic conditions could challenge the BHCs, even though they have been deemed to have adequate capital levels under SCAP. This report recommends that the Federal Reserve complete a final 2-year SCAP analysis, and apply lessons learned from SCAP to improve transparency of bank supervision, examiner guidance, risk identification and assessment, and regulatory coordination. The Federal Reserve agreed with our five recommendations and noted current actions that it has underway to address them. Treasury agreed with the report's findings.

section_title: Letter
paragraphs: The recent financial crisis seriously undermined confidence in the nation’s  financial system and institutions. In February 2009, to help restore  confidence, the U.S. Department of the Treasury (Treasury) announced  the Financial Stability Plan, which established the Supervisory Capital  Assessment Program (SCAP). SCAP, as implemented by the Board of  Governors of the Federal Reserve System (Federal Reserve) and other  federal banking regulators, was to determine through a stress test  whether the largest 19 U.S. bank holding companies (BHC) had enough  capital for the next 2 years (2009-2010) to support their lending activities  and survive a second similar economic shock. As of December 31, 2008,  the largest 19 BHCs accounted for approximately 67 percent of the assets  and more than 50 percent of loans in the U.S. banking system. BHCs that  were found to need additional capital would be allowed, and were  encouraged, to raise the funds privately, but if they could not, Treasury  would provide capital infusions using funding available under the  Troubled Asset Relief Program’s (TARP) Capital Assistance Program  (CAP). However, Treasury made no investments under CAP and  terminated the program in November 2009. When SCAP was first  announced in February 2009, and again around the time the Federal  Reserve released the results of the stress test in May 2009, some  academics, market participants, and others raised concerns about the test,  noting that the assumptions used in the more adverse economic scenario  were not severe enough and that the test did not account for differences in  institutions’ business models.
As part of GAO’s continued analysis and monitoring of Treasury’s process  for implementing the Emergency Economic Stabilization Act of 2008, this  report on the stress test expands on SCAP activities that we reported on in  June 2009. Specifically, this report (1) describes the process used to  design and conduct the stress test and participants’ views on the process,  (2) describes the extent to which the stress test achieved its goals and  compares its estimates with the BHCs’ actual results, and (3) identifies the  lessons regulators and BHCs learned from SCAP and examines how each  are using those lessons to enhance their risk identification and assessment  practices.
To meet the report’s objectives, we reviewed the Federal Reserve’s The  Supervisory Capital Assessment Program: Design and Implementation  (SCAP design and implementation document) dated April 24, 2009, and  The Supervisory Capital Assessment Program: Overview of Results  (SCAP results document) dated May 7, 2009. In addition to the publicly  released BHC-level loss estimates, we analyzed the initial stress test  results that the Federal Reserve provided to each BHC, the subsequent  adjustments the Federal Reserve made to these results, and its reasons for  making them. We also reviewed the BHCs’ quarterly regulatory filings,  such as the Federal Reserve’s 2009 Consolidated Financial Statements for  Bank Holding Companies—FR Y-9C (Y-9C); form 10-Qs and annual form  10-Ks; speeches, testimonies, and articles regarding SCAP and stress  testing; and BHC presentations to shareholders and earnings reports. To  more completely understand the execution of SCAP, we completed a  literature search of stress tests that other entities have conducted, such as  the Committee of European Banking Supervisors and the International  Monetary Fund. We also reviewed the Congressional Oversight Panel’s  analysis of SCAP. In addition, we reviewed the capital plans of the 10  BHCs that were required to raise capital to satisfy their SCAP capital  requirement. We collected and analyzed data on the BHCs’ actual  performance from a private financial database of public information and  compared it with the 2-year SCAP estimates and with GAO’s 1-year pro  rata loss estimates for the more adverse scenario (pro rata loss estimate).  GAO calculated the pro rata loss estimates by dividing the SCAP more  adverse 2-year loss estimates by 2. This pro rata estimate methodology has  some limitations, because losses, expenses, revenues, and changes to  reserves are historically unevenly distributed and loss rates over a 2-year  period in an uncertain economic environment can follow an inconsistent  path. However, the Federal Reserve, the Office of the Comptroller of the  Currency (OCC), credit rating agencies, an SNL Financial analyst, and all  of the BHCs we interviewed that are tracking performance relative to  SCAP estimates are also using the same methodology. We obtained  Federal Reserve and BHCs comments on our performance comparison.  Further, we interviewed regulatory and BHC officials to get their views on  the SCAP stress test. Regulatory officials included bank examiners,  economists, and attorneys from the Federal Reserve; the Federal Reserve  district banks; the OCC; the Federal Deposit Insurance Corporation  (FDIC); the Office of Thrift Supervision; and BHC senior officials,  including chief financial officers and chief risk officers, who participated  in the SCAP stress test and were responsible for coordinating and  discussing the results with regulators. These officials represented several  types of BHCs, including traditional, custodial, investment, auto finance,  and credit card institutions. Finally, we met with credit rating agency  officials to get their views on SCAP and understand their own stress  testing practices for banks. For additional information on the scope and  methodology for this engagement, see appendix I.
We conducted this performance audit from August 2009 to September 2010  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Despite efforts undertaken by TARP to bolster capital of the largest  financial institutions, market conditions in the beginning of 2009 were  deteriorating and public confidence in the ability of financial institutions  to withstand losses and to continue lending were further declining. On  February 10, 2009, Treasury announced the Financial Stability Plan, which  outlined measures to address the financial crisis and restore confidence in  the U.S. financial and housing markets. The goals of the plan were to (1)  restart the flow of credit to consumers and businesses, (2) strengthen  financial institutions, and (3) provide aid to homeowners and small  businesses. Under SCAP, the stress test would assess the ability of the  largest 19 BHCs to absorb losses if economic conditions deteriorated  further in a hypothetical “more adverse” scenario, characterized by a  sharper and more protracted decline in gross domestic product (GDP)  growth, a steeper drop in home prices, and a larger rise in the  unemployment rate than in a baseline consensus scenario. BHCs that were  found not to meet the SCAP capital buffer requirement under the “more  adverse” scenario would need to provide a satisfactory capital plan to  address any shortfall by raising funds, privately if possible. CAP, which  was a key part of the plan, would provide backup capital to financial  institutions unable to raise funds from private investors. Any of the 19  BHCs that participated in the stress test and had a capital shortfall could  apply for capital from CAP immediately if necessary. The timeline in  figure 1 provides some highlights of key developments in the  implementation of SCAP.
In a joint statement issued on February 10, 2009, Treasury, along with the  Federal Reserve, FDIC, and OCC (collectively referred to as the SCAP  regulators), committed to design and implement the stress test. According  to a Treasury official, the department generally did not participate in the  design or implementation of SCAP, but was kept informed by the Federal  Reserve during the stress test. The SCAP regulators developed economic  assumptions to estimate the potential impact of further losses on BHCs’  capital under two scenarios. The baseline scenario reflected the consensus  view about the depth and duration of the recession, and the more adverse  scenario reflected a plausible but deeper and longer recession than the  consensus view. Regulators then calculated how much capital, if any, was  required for each BHC to achieve the required SCAP buffer at the end of  2010 under the more adverse scenario.
The SCAP assessment examined tier 1 capital and tier 1 common capital,  and the BHCs were required to raise capital to meet any identified capital  shortfall (either tier 1 capital or tier 1 common capital). Tier 1 risk-based  capital is considered core capital—the most stable and readily available  for supporting a bank’s operations and includes elements such as common  stock and noncumulative perpetual preferred stock. SCAP’s focus on tier  1 common capital, a subset of tier 1 capital, reflects the recent regulatory  push for BHCs to hold a higher quality of capital. The focus on common  equity reflected both the long held view by bank supervisors that common  equity should be the dominant component of tier 1 capital and increased  market scrutiny of common equity ratios, driven in part by deterioration in  common equity during the financial crisis. Common equity offers  protection to more senior parts of the capital structure because it is the  first to absorb losses in the capital structure. Common equity also gives a  BHC greater permanent loss absorption capacity and greater ability to  conserve resources under stress by changing the amount and timing of  dividends and other distributions.
To protect against risks, financial regulators set minimum standards for  the capital that firms are to hold. However, SCAP set a one-time  minimum capital buffer target for BHCs to hold to protect against losses  and preprovision net revenue (PPNR) that were worse than anticipated  during the 2009 to 2010 period. For the purposes of SCAP, the one-time  target capital adequacy ratios are at least 6 percent of risk-weighted assets  in tier 1 capital and at least 4 percent in tier 1 common capital projected as  of December 31, 2010. For the purposes of the projection, the regulators  assumed that BHCs would suffer the estimated losses and earned revenues  in 2009 and 2010 in the more adverse scenario. SCAP regulators conducted  the stress test strictly on the BHCs’ assets as of December 31, 2008,  and—with the exception of off-balance sheet positions subject to  Financial Accounting Statements No. 166 and 167, which assumed in the  analysis to come on balance sheet as of January 1, 2010—did not take int account any changes in the composition of their balance sheets over the year time frame.
Stress testing is one of many risk management tools used by both BHCs  and regulators. Complex financial institutions need management  information systems that can help firms to identify, assess, and manage a  full range of risks across the whole organization arising from both internal  and external sources and from assets and obligations that are found both  on and off the BHC’s balance sheet. This approach is intended to help  ensure that a firmwide approach to managing risk has been viewed as  being crucial for responding to rapid and unanticipated changes in  financial markets. Risk management also depends on an effective  corporate governance system that addresses risk across the institution and  also within specific areas, such as subprime mortgage lending. The board  of directors, senior management, audit committee, internal auditors,  external auditors, and others play important roles in effectively operating  a risk management system. The different roles of each of these groups  represent critical checks and balances in the overall risk management  system. However, the management information systems at many financial  institutions have been called into question since the financial crisis began  in 2007. Identified shortcomings, such as lack of firmwide stress testing,  have led banking organizations and their regulators to reassess capital  requirements, risk management practices, and other aspects of bank  regulation and supervision.
Stress testing has been used throughout the financial industry for more  than 10 years, but has recently evolved as a risk management tool in  response to the urgency of the financial crisis. The main evolution is  towards the use of comprehensive firmwide stress testing as an integral  and critical part of firms’ internal capital adequacy assessment processes.  In the case of SCAP, the intent of the stress test was to help ensure that  the capital held by a BHC is sufficient to withstand a plausible adverse  economic environment over the 2-year time frame ending December 31,  2010. The Basel Committee on Banking Supervision (Basel Committee)  issued a document in May 2009 outlining several principles for sound  stress testing practices and supervision. The Basel Committee document  endorses stress testing by banks as a part of their internal risk  management to assess the following:    Credit risk. The potential for financial losses resulting from the failure of  a borrower or counterparty to perform on an obligation.
Market risk. The potential for financial losses due to an increase or  decrease in the value of an asset or liability resulting from broad price  movements; for example, in interest rates, commodity prices, stock prices,  or the relative value of currencies (foreign exchange).
Liquidity risk. The potential for financial losses due to an institution’s  failure to meet its obligations because it cannot liquidate assets or obtain  adequate funding.
Operational risk. The potential for unexpected financial losses due to a  wide variety of institutional factors including inadequate information  systems, operational problems, breaches in internal controls, or fraud.
Legal risk. The potential for financial losses due to breaches of law or  regulation that may result in heavy penalties or other costs.
Compliance risk. The potential for loss arising from violations of laws or  regulations or nonconformance with internal policies or ethical standards.
Strategic risk. The potential for loss arising from adverse business  decisions or improper implementation of decisions.
Reputational risk. The potential for loss arising from negative publicity  regarding an institution’s business practices.
section_title: SCAP Process Generally Viewed as Promoting Coordination, Transparency, and Capital Adequacy
paragraphs: According to SCAP regulators and many market participants we  interviewed, the process used to design and implement SCAP was  effective in promoting coordination and transparency among the  regulators and participating BHCs, but some SCAP participants we  interviewed expressed concerns about the process. The majority of  supervisory and bank industry officials we interviewed stated that they  were satisfied with how SCAP was implemented, especially considering  the stress test’s unprecedented nature, limited time frame, and the  uncertainty in the economy. SCAP established a process for (1)  coordinating and communicating among the regulators and with the BHCs  and (2) promoting transparency of the stress test to the public. In addition,  according to regulators, the process resulted in a methodology that yielded  credible results and by design helped to assure that the BHCs would be  sufficiently capitalized to weather a more adverse economic downturn.
subsections: section_title: SCAP Process Included Coordination and Communication among the Federal Bank Regulators and with the BHCs
paragraphs: Robust coordination and communication are essential to programs like  SCAP when bringing together regulatory staff from multiple agencies and  disciplines to effectively analyze complex financial institutions and  understand the interactions among multiple layers of risk. Moreover,  supervisory guidance emphasizes the importance of coordination and  communication among regulators to both effectively assess banks and  conduct coordinated supervisory reviews across a group of peer  institutions, referred to as “horizontal examinations.”
The regulators implemented each phase of SCAP in a coordinated  interagency fashion. Also, while some disagreed, most regulators and  market participants we interviewed were satisfied with the level of  coordination and communication. They also thought that the SCAP  process could serve as a model for future supervisory efforts. The  regulators executed the SCAP process in three broad phases:  In the first phase, the Analytical Group, comprising interagency  economists and supervisors, generated two sets of economic conditions— a baseline scenario and a more adverse scenario with a worse-than- expected economic outcome—and then used these scenarios to aid in  estimating industrywide indicative loan loss rates. To develop these  scenarios, the Analytical Group used three primary indicators of economic  health: the U.S. GDP, housing prices in 10 key U.S. cities, and the annual  average U.S. unemployment rate. The baseline scenario reflected the  consensus view of the course for the economy as of February 2009,  according to well-known professional economic forecasters. The Federal  Reserve developed the more adverse scenario from the baseline scenario  by taking into account the historical accuracy of the forecasts for  unemployment and the GDP and the uncertainty of the economic outlook  at that time by professional forecasters. The Federal Reserve also used  regulators’ judgment about the appropriate severity of assumed additional  stresses against which BHCs would be required to hold a capital buffer,  given that the economy was already in a recession at the initiation of  SCAP.
In the second phase, several Supervisory Analytical and Advisory Teams— comprising interagency senior examiners, economists, accountants,  lawyers, financial analysts, and other professionals from the SCAP  regulators—collected, verified, and analyzed each BHC’s estimates for  losses, PPNR, and allowance for loan and lease losses (ALLL). The teams  also collected additional data to evaluate the BHC’s estimates, and to  allow supervisors to develop their own independent estimates of losses for  loans, trading assets, counterparty credit risk, and securities and PPNR for  each BHC.
In the third phase, the Capital Assessment Group, comprising interagency  staff, served as the informal decision-making body for SCAP. The Capital  Assessment Group developed a framework for combing the Supervisory  Analytical and Advisory Teams’ estimates with other independent  supervisory estimates of loan losses and resources available to absorb  these losses. They evaluated the estimates by comparing across BHCs  and by aggregating over the 19 BHCs to check for consistency with the  specified macroeconomic scenarios to calculate the amount, if any, of  additional capital needed for each BHC to achieve the SCAP buffer target  capital ratios as of December 31, 2010, in the more adverse economic  environment. Lastly, the Capital Assessment Group set two deadlines: (1)  June 8, 2009, for BHCs requiring capital to develop and submit a capital  plan to the Federal Reserve on how they would meet their SCAP capital  shortfall and (2) November 9, 2009, for these BHCs to raise the required  capital.
A key component of this process was the involvement of multidisciplinary  interagency teams that leveraged the skills and experiences of staff from  different disciplines and agencies. The Federal Reserve, OCC, and FDIC  had representatives on each SCAP team (the Analytical Group,  Supervisory Analytical and Advisory Teams, and the Capital Assessment  Group). For example, OCC officials said that they contributed to the  development of quantitative models required for the implementation of  SCAP and offered their own models for use in assessing the loss rates of  certain portfolios. In addition, each of the SCAP regulators tapped  expertise within their organization for specific disciplines, such as  accounting, custodial banking, macroeconomics, commercial and industry  loan loss modeling, and consumer risk modeling. According to the FDIC,  the broad involvement of experts from across the agencies helped validate  loss assumptions and also helped improve confidence in the results.  Further, these officials noted that the SCAP process was enhanced  because productive debate became a common event as team members  from different regulatory agencies and disciplines brought their own  perspectives and ideas to the process. For example, some SCAP staff  argued for a more moderate treatment of securities in BHCs’ available for  sale portfolios, which would have been consistent with generally accepted  accounting principles under a new change in accounting standards. They  maintained that the modified accounting standard for declines in market  value (and discounting the impact of liquidity premia) that had been  implemented after the stress test was announced and before the numbers  had been finalized was in some ways more reflective of the realized credit  loss expectations for the affected securities. After significant discussion,  the regulators decided to allow for the accounting change in the baseline  loss estimates, but not in the more adverse scenario estimates. They  believed that under the more adverse scenario there was a heightened  possibility of increased liquidity demands on banks and that many  distressed securities would need to be liquidated at distressed levels.  Consequently, for securities found to be other than temporarily impaired  in the more adverse scenario, they assumed the firm would have to realize  all unrealized losses (i.e., write down the value of the security to market  value as of year end 2008). Similarly, some staff argued against adopting  other changes in accounting standards that were expected to impact  BHCs’ balance sheets, including their capital adequacy. Primary among  these was the inclusion of previously off-balance sheet items. As noted  above, ultimately, the more conservative approach prevailed and the  expected inclusion of these assets was addressed in SCAP.
To facilitate coordination, the Federal Reserve instituted a voting system  to resolve any contentious issues, but in practice differences among  regulators were generally resolved through consensus. When SCAP  regulators met, the Federal Reserve led the discussions and solicited input  from other regulators. For example, officials from OCC and FDIC both  told us that they felt that they were adequately involved in tailoring the  aggregate loss estimates to each BHC as part of the determination of each  BHC’s SCAP capital requirement. SCAP regulators were also involved in  drafting the design and results documents, which were publicly released  by the Federal Reserve.
Representatives from most of the BHCs were satisfied with the SCAP  regulators’ coordination and communication. Many of the BHC officials  stated that they were generally impressed with the onsite SCAP teams and  said that these teams improved the BHCs’ coordination and  communication with the regulators. BHC officials said that they usually  received answers to their questions in a timely manner, either during  conference calls held three times a week, through the distribution of  answers to frequently asked questions, or from onsite SCAP examiners.  Collecting and aggregating data were among the most difficult and time- consuming tasks for BHCs, but most of them stated that the nature of the  SCAP’s requests were clear. At the conclusion of SCAP, the regulators  presented the results to each of the institutions showing the final numbers  that they planned to publish.
section_title: Market Participants Generally Agreed that the SCAP Process Was Transparent
paragraphs: The SCAP process included steps to promote transparency, such as the  release of key program information to SCAP BHCs and the public.  According to SCAP regulators, BHCs, and credit rating agency officials we  interviewed, the release of the results provided specific information on the  financial health and viability of the 19 largest BHCs regarding their ability  to withstand additional losses during a time of significant uncertainty.  Many experts have said that the lack of transparency about potential  losses from certain assets contributed significantly to the instability in  financial markets during the current crisis. Such officials also stated that  publicly releasing the methodology and results of the stress test helped  strengthen market confidence. Further, many market observers have  commented that the Federal Reserve’s unprecedented disclosure of  sensitive supervisory information for each BHC helped European bank  regulators decide to publicly release detailed results of their own stress  tests in July 2010.
Not all SCAP participants agreed that the SCAP process was fully  transparent. For example, some participants questioned the transparency  of certain assumptions used in developing the stress test. According to  BHC officials and one regulator, the Federal Reserve could have shared  more detailed information about SCAP loss assumptions and calculations  with BHCs. According to several BHC officials, the Federal Reserve did  not fully explain the methodology for estimating losses but expected BHC  officials to fully document and provide supporting data for all of their  assumptions. Without knowing the details of the methodology, according  to some BHC officials, they could not efficiently provide all relevant  information to SCAP examiners.
section_title: SCAP Was Designed to Help Ensure That BHCs Were Adequately Capitalized Under the More Adverse Economic Scenario
paragraphs: SCAP regulators aimed to ensure that SCAP sufficiently stressed BHCs’  risk exposures and potential PPNR under the more adverse scenario. To  accomplish this, the regulators made what they viewed to be conservative  assumptions and decisions in the following areas. First, the regulators  decided to stress only assets that were on the BHCs’ balance sheets as of  December 31, 2008, (i.e., a static approach) without accounting for new  business activity. According to BHC officials, new loans were thought to  have generally been of better quality than legacy loans because BHCs had  significantly tightened their underwriting standards since the onset of the  financial crisis. As a result, BHCs would have been less likely to charge- off these loans within the SCAP time period ending December 31, 2010,  resulting in the potential for greater reported revenue estimates for the  period. By excluding earnings from new business, risk-weighted assets  were understated, charge-off rates were overstated, and projected capital  levels were understated.
Second, SCAP regulators generally did not allow the BHCs to cut expenses  to address the anticipated drop in revenues under the more adverse  scenario. However, some BHC officials told us that they would likely cut  expenses, including initiating rounds of layoffs, if the economy performed  in accordance with the more adverse economic scenario, especially if they  were not generating any new business. Federal Reserve officials noted that  BHCs were given credit in the stress test for cost cuts made in the first  quarter of 2009.
Third, some BHCs were required to assume an increase in their ALLL as of  the end of 2010, if necessary, to ensure adequate reserves relative to their  year end 2010 portfolio. Some BHC officials believed that this requirement  resulted in the BHCs having to raise additional capital because the  required ALLL increases were subtracted from the revenue estimates in  calculating the resources available to absorb losses. This meant that some  BHCs judged to have insufficient year end 2010 reserve adequacy had to  account for this shortcoming in the calculation of capital needed to meet  the SCAP targeted capital requirements as of the end of 2010 while  maintaining a sufficient ALLL for 2011 losses under the more adverse  economic scenario. According to some BHCs, the size of the 2010 ALLL  was severe given the extent of losses are already included in the 2009 and  2010 loss estimates and effectively stressed BHCs for a third year.
Finally, according to many BHC officials and others, the calculations used  to derive the loan loss rates and other assumptions to stress the BHCs  were conservative (i.e., more severe). For example, the total loan loss rate  estimated by the SCAP regulators was 9.1 percent, which was greater than  the historical 2-year loan loss rates at all commercial banks from 1921 until  2008, including the worst levels seen during the Great Depression (see  figure 2). However, the macroeconomic assumptions of the more adverse  scenario, which we will discuss later in the report, did not meet the  definition of a depression. Specifically, a 25 percent unemployment rate  coupled with economic contraction is indicative of a depression. In  contrast, the more adverse scenario estimated approximately a 10 percent  unemployment rate with some economic growth in late 2010.
SCAP regulators also estimated ranges for loan loss rates within specific  loan categories using the baseline and more adverse scenarios as guides.  They used a variety of methods to tailor loan losses to each BHC,  including an analysis of past BHC losses and quantitative models, and  sought empirical support from BHCs regarding the risk level of their  portfolios. However, some BHCs told us that the Federal Reserve made  substantial efforts to help ensure conformity with the indicative loan loss  rates while incorporating BHC-specific information where possible and  reliable. Table 1 compares the different indicative loan loss rate ranges  under the more adverse scenario for each asset category with actual losses  in 2009 for SCAP BHCs and the banking industry. Some BHCs stated that  the resulting loan loss rates were indicative of an economy worse off than  that represented by the more adverse macroeconomic assumptions,  although they recognized the need for the more conservative approach.
However, nearly all agreed that the loan loss rates were a more important  indication of the stringency of SCAP than the assumptions.
After the public release of the SCAP methodology in April 2009, many  observers commented that the macroeconomic assumptions for a more  adverse economic downturn were not severe enough given the economic  conditions at that time. In defining a more adverse economic scenario, the  SCAP regulators made assumptions about the path of the economy using  three broad macroeconomic indicators—changes in real GDP, the  unemployment rate, and home prices—during the 2-year SCAP period  ending December 2010. The actual performances of GDP and home prices  have performed better than assumed under the more adverse scenario.  However, the actual unemployment rate has more closely tracked the  more adverse scenario (see figure 3). Further, as noted earlier, some  regulatory and BHC officials have indicated that the loan loss rates that  the regulators subsequently developed were more severe than one would  have expected under the macroeconomic assumptions. While our analysis  of actual and SCAP estimated indicative loan losses (see table 1) is  generally consistent with this view, these estimates were developed at a  time of significant uncertainty about the direction of the economy and the  financial markets, as well as an unprecedented deterioration in the U.S.  housing markets.
section_title: While SCAP Increased Capital Levels and Improved Confidence in the Banking System, BHCs Could Face Ongoing Challenges
paragraphs: SCAP largely met its goals of increasing the level and quality of capital  held by the 19 largest BHCs and, more broadly, of strengthening market  confidence in the banking system. The stress test identified 10 of the 19  BHCs as needing to raise a total of about $75 billion in additional capital.  The Federal Reserve encouraged the BHCs to raise common equity via  private sources—for example, through new common equity issuances,  conversion of existing preferred equity to common equity, and sales of  businesses or portfolios of assets. Nine of the 10 BHCs were able to raise  the required SCAP amount of new common equity in the private markets  by the November 9, 2009, deadline (see table 2). Some of these BHCs also  raised capital internally from other sources. GMAC LLC (GMAC) was the  only BHC that was not able to raise sufficient private capital by the  November 9, 2009, deadline. On December 30, 2009, Treasury provided  GMAC with a capital investment of $3.8 billion to help fulfill its SCAP  capital buffer requirement, drawing funds from TARP’s Automotive  Industry Financing Program. A unique and additional element of the  estimated losses for GMAC included the unknown impact of possible  bankruptcy filings by General Motors Corporation (GM) and Chrysler LLC  (Chrysler). Thus, a conservative estimate of GMAC’s capital buffer was  developed in response to this possibility. The Federal Reserve, in  consultation with Treasury, subsequently reduced GMAC’s SCAP required  capital buffer by $1.8 billion—$5.6 billion to $3.8 billion—primarily to  reflect the lower-than-estimated actual losses from the bankruptcy  proceedings of GM and Chrysler. GMAC was the only company to have its  original capital buffer requirement reduced.
Capital adequacy generally improved across all 19 SCAP BHCs during  2009. As shown in table 3, the largest gains were in tier 1 common capital,  which increased by about 51 percent in the aggregate across the 19 BHCs,  rising from $412.5 billion on December 31, 2008, to $621.9 billion by  December 31, 2009. On an aggregate basis, the tier 1 common capital ratio  at BHCs increased from 5.3 percent to 8.3 percent of risk-weighted assets  (compared with the SCAP threshold of 4 percent at the end of 2010). The  tier 1 risk-based capital ratio also grew from 10.7 percent to 11.3 percent  of risk-weighted assets (compared with the SCAP threshold of 6 percent at  the end of 2010). While these ratios were helped to some extent by  reductions in risk-weighted assets, which fell 4.3 percent from $7.815  trillion on December 31, 2008, to $7.481 trillion on December 31, 2009, the  primary driver of the increases was the increase in total tier 1 common  capital.
The quality of capital—measured as that portion of capital made up of tier  1 common equity—also increased across most of the BHCs in 2009. The  tier 1 common capital ratio increased at 17 of the 19 BHCs between the  end of 2008 and the end of 2009 (see table 4). Citigroup Inc. (Citigroup)  and The Goldman Sachs Group, Inc. (Goldman Sachs) had the largest  increases in tier 1 common capital ratios—747 and 450 basis points,  respectively. However, GMAC’s tier 1 common capital ratio declined by  155 basis points in this period to 4.85 percent. MetLife, Inc. was the only  other BHC to see a drop in its tier 1 common capital ratio, which fell by 33  basis points to 8.17 percent and still more than double the 4 percent target.  Based on the SCAP results document, the 2008 balances in the table  include the impact of certain mergers and acquisitions, such as Bank of  America Corporation’s (Bank of America) purchase of Merrill Lynch & Co.  Inc. Further, the increase in capital levels reflects the capital that was  raised as a result of SCAP.
As previously stated by interviewees, the unprecedented public release of  the stress test results helped to restore investors’ confidence in the  financial markets. Some officials from participating BHCs and credit rating  agencies also viewed the BHCs’ ability to raise the capital required by the  stress test as further evidence of SCAP’s success in increasing market  confidence and reducing uncertainty. But some expressed concerns that  the timing of the announcement of SCAP on February 10, 2009—nearly 3  months before the results were released on May 7, 2009—may have  intensified market uncertainty about the financial health of the BHCs.
A broad set of market indicators also suggest that the public release of  SCAP results may have helped reduce uncertainty in the financial markets  and increased market confidence. For example, banks’ renewed ability to  raise private capital reflects improvements in perceptions of the financial  condition of banks. Specifically, banks and thrifts raised significant  amounts of common equity in 2008, totaling $56 billion. Banks and thrifts  raised $63 billion in common equity in the second quarter of 2009 (see  figure 4). The substantial increase in second quarter issuance of common  equity occurred after the stress test results were released on May 7, 2009,  and was dominated by several SCAP institutions.
Similarly, stock market prices since the release of the stress test results in  May 2009 through October 2009 improved substantially in the overall  banking sector and among the 18 public BHCs that participated in SCAP  (see figure 5). The initial increase since May 2009 also suggests that  SCAP may have helped bolster investor and public confidence. However,  equity markets are generally volatile and react to a multitude of events.
Credit default swap spreads, another measure of confidence in the  banking sector, also improved. A credit default swap is an agreement in  which a buyer pays a periodic fee to a seller in exchange for protection  from certain credit events such as bankruptcy, failure to pay debt  obligations, or a restructuring related to a specific debt issuer or issues  known as the reference entity. Therefore, the credit default swap spread,  or market price, is a measure of the credit risk of the reference entity, with  a higher spread indicating a greater amount of credit risk. When the  markets’ perception of the reference entity’s credit risk deteriorates or  improves, the spread generally will widen or tighten, respectively.  Following the SCAP results release in May 2009, the credit default swap  spreads continued to see improvements (see figure 6). While many forces  interact to influence investors’ actions, these declining spreads suggest  that the market’s perception of the risk of banking sector defaults was  falling. Further, the redemption of TARP investments by some banking  institutions demonstrated that regulators believed these firms could  continue to serve as a source of financial and managerial strength, as well  as fulfill their roles as intermediaries that facilitate lending, while both  reducing reliance on government funding and maintaining adequate capital  levels. This positive view of the regulators may also have helped increase  market confidence in the banking system (see appendix II for details on  the status of TARP investments in the institutions participating in SCAP).
subsections: section_title: The 19 Tested BHCs Experienced Better Performance Than a Pro Rata Estimate under the More Adverse Scenario
paragraphs: As of the end of 2009, while the SCAP BHCs generally had not experienced  the level of losses that were estimated on a pro rata basis under the stress  test’s more adverse economic scenario, concerns remain that some banks  could absorb potentially significant losses in certain asset categories that  would erode capital levels. Collectively, the BHCs’ total loan losses of  $141.2 billion were approximately 38 percent less than the GAO-calculated  $229.4 billion in pro rata losses under the more adverse scenario for 2009  (see table 5). The BHCs also experienced significant gains in securities  and trading and counterparty credit risk portfolios compared with  estimated pro rata losses under SCAP. Total resources other than capital  to absorb losses (resources) were relatively close to the pro rata amount,  exceeding it by 4 percent.
In tracking BHCs’ losses and resources against the SCAP estimates, we  compared the actual results with those estimated under the more adverse  scenario. We used the 2-year estimates of the more adverse scenario from  the SCAP results and annualized those amounts by dividing them in half  (the “straight line” method) to get pro rata loss estimates for 2009 because  the SCAP regulators did not develop estimates on a quarterly or annual  basis. A key limitation of this approach is that it assumes equal  distribution of losses, revenues, expenses, and changes to reserves over  time, although these items were unlikely to be distributed evenly over the  2-year period. Another important consideration is that actual results were  not intended and should not be expected to align with the SCAP  projections. Actual economic performance in 2009 differed from the SCAP  macroeconomic variable inputs, which were based on a scenario that was  more adverse than was anticipated or than occurred, and other forces in  the business and regulatory environment could have influenced the timing  and level of losses. Appendix I contains additional details on our  methodology, including our data sources and calculations, for tracking  BHCs’ financial performance data.
section_title: Losses Varied by Individual BHCs
paragraphs: Although the 19 BHCs’ actual combined losses were less than the 2009 pro  rata loss estimates for the more adverse scenario, the loss rates varied  significantly by individual BHCs. For example, most of the BHCs had  consumer and commercial loan losses that were below the pro rata loss  estimates, but three BHCs—GMAC, Citigroup, and SunTrust Banks Inc.  (SunTrust)—exceeded these estimates in at least one portfolio (see figure  7). GMAC was the only one with 2009 loan losses on certain portfolios that  exceeded SCAP’s full 2-year estimate. Specifically, GMAC exceeded the  SCAP 2-year estimated losses in the first-lien, second/junior lien, and  commercial real estate portfolios and the 1-year pro rata losses in the  “Other” portfolio; Citigroup exceeded the 1-year pro rata estimated losses  in the commercial and industrial loan portfolio; and SunTrust exceeded  the 1-year estimated losses in the first-lien and credit card portfolios.  Appendix III provides detailed data on the individual performance of each  of the BHCs.
GMAC faced particular challenges in the first year of the assessment  period and posed some risk to the federal government, a majority equity  stakeholder. GMAC’s loan losses in its first-lien portfolio were $2.4  billion, compared with the $2 billion projected for the full 2-year period. In  the second/junior lien portfolio, GMAC saw losses of $1.6 billion,  compared with the $1.1 billion estimated losses for the 2 years. GMAC  experienced losses of $710 million in its commercial real estate portfolio,  compared with $600 million projected for the full 2-year period. Further, in  its “Other” portfolio (which is comprised of auto leases and consumer auto  loans), GMAC’s losses were $2.1 billion, exceeding the 1-year pro rata $2  billion loss estimate. With a tier 1 common capital ratio of 4.85 percent— just more than the SCAP threshold of 4 percent—at the end of 2009, GMAC  has a relatively small buffer in the face of potential losses.
GMAC’s position should be placed in context, however, because it is  relatively unique among the SCAP participants. It was the only nonpublicly  traded participant, and the federal government owns a majority equity  stake in the company as a result of capital investments made through the  Automotive Industry Financing Program under TARP. Further, GMAC’s  core business line—financing for automobiles—is dependent on the  success of efforts to restructure, stabilize, and grow General Motors  Company and Chrysler Group LLC. Finally, the Federal Reserve told us  that because GMAC only recently became a BHC and had not previously  been subject to banking regulations, it would take some time before  GMAC was fully assimilated into a regulated banking environment. To  improve its future operating performance and better position itself to  become a public company in the future, GMAC officials stated that the  company posted large losses in the fourth quarter of 2009 as result of  accelerating its recognition of lifetime losses on loans. In addition, the  company has been restructuring its operations and recently sold off some  nonperforming assets. However, the credit rating agencies we met with  generally believed that there could still be further losses at GMAC,  although the agencies were less certain about the pace and level of those  losses. Two of the agencies identified GMAC’s Residential Capital, LLC  mortgage operation as the key source of potential continued losses.
section_title: BHCs Are Generally Not Experiencing the Level of Securities and Trading Losses That Were Estimated under the Pro Rata More Adverse Scenario, and Some Have Recorded Gains
paragraphs: Given that market conditions have generally improved, the BHCs’  investments in securities and trading account assets performed  considerably better in 2009 than had been estimated under the pro rata  more adverse scenario. The SCAP assessment of the securities portfolio  consisted of an evaluation for possible impairment of the portfolio’s  assets, including Treasury securities, government agency securities,  sovereign debt, and private sector securities. In the aggregate, the  securities portfolio has experienced a gain of $3.5 billion in 2009,  compared with a pro rata estimated loss of $17.6 billion under the stress  test’s more adverse scenario. As figure 8 shows, 5 of the 19 BHCs recorded  securities losses in 2009, 13 recorded gains, and 1 (Morgan Stanley)  recorded no gain or loss. Losses were projected at 17 of the BHCs under  the pro rata more adverse scenario, and SCAP regulators did not consider  the remaining 2 BHCs (American Express Company and Morgan Stanley)  to be applicable for this category. In the securities portfolio, The Bank of  New York Mellon Corporation had losses greater than estimated under  SCAP for the full 2-year period. The variances could be due to a number  of factors, including the extent to which a BHC decides to deleverage, how  their positions react to changing market values, and other factors.
To estimate trading and counterparty losses, SCAP regulators assumed  that these investments would be subject to the change in value of a  proportional level as experienced in the last half of 2008. The trading  portfolio shows an even greater difference between the 1-year pro rata  estimates and the actual performance—a gain of $56.9 billion in 2009  rather than the pro rata $49.7 billion estimated loss under the more  adverse scenario (see table 5). The stress test only calculated trading and  counterparty credit loss estimates for the five BHCs with trading assets  that exceeded $100 billion. All five had trading gains as opposed to  losses, based on the publicly available data from the Y-9C. These gains  were the result of a number of particular circumstances. First, the extreme  spreads and risk premium resulting from the lack of liquidity during the  financial crisis—especially in the second half of 2008—reversed in 2009,  improving the pricing of many risky trading assets that remained on BHCs’  balance sheets. Because the trading portfolio is valued at fair value, it had  been written down for the declines in value that occurred throughout 2008  and the first quarter of 2009 and saw significant gains when the market  rebounded through the remainder of 2009. Second, the crisis led to the  failure or absorption of several large investment banks, reducing the  number of competitors and, according to our analysis of Thomson Reuters  Datastream, increased market share and pricing power for the remaining  firms. Finally, the Federal Reserve’s low overnight bank lending rates  (near 0 percent) have prevailed for a long period and have facilitated a  favorable trading environment for BHCs. This enabled BHCs to fund  longer-term, higher yielding assets in their trading portfolios with  discounted wholesale funding (see figure 9).
section_title: Potential Losses in Consumer and Commercial Credit Continue to Pose a Challenge
paragraphs: Potentially large losses in consumer and commercial loans continue to  challenge SCAP BHCs, and addressing these challenges depends on a  variety of factors, including, among other things, the effectiveness of  federal efforts to reduce foreclosures in the residential mortgage market.  The BHCs absorbed nearly $400 billion in losses in the 18 months ending  December 31, 2008. As they continue to experience the effects of the  recent financial crisis, estimating precisely how much more they could  lose is difficult. In March 2010, officials from two credit rating agencies  indicated that 50 percent or more of the losses the banking industry was  expected to incur during the current financial crisis could still be realized  if the economy were to suffer further stresses.
Data for the 19 BHCs show a rapid rise in the percentage of nonperforming  loans over the course of 2009 (see figure 10). Specifically, total  nonperforming loans grew from 1 percent in the first quarter of 2007 to 6.6  percent in the fourth quarter of 2009 for SCAP BHCs. In particular,  increases in total nonperforming loans were driven by significant growth  in nonperforming first-lien mortgages and commercial real estate loans.  Standard & Poor’s Corporation noted that many nonperforming loans may  ultimately have to be charged-off, exposing the BHCs to further potential  losses. According to the credit rating agencies that we interviewed, federal  housing policy to aid homeowners who are facing foreclosures, as well as  time lags in the commercial real estate markets, will likely continue to  affect the number of nonperforming loans for the remainder of the SCAP  time frame (December 2010).
section_title: The Economic and Regulatory Environment Could Impact BHCs’ Net Revenues and Loss Reserves
paragraphs: The total amount of resources other than capital to absorb losses  (resources) has tracked the amount GAO prorated under the stress test’s  more adverse scenario. Resources measure how much cushion the BHCs  have to cover loans losses. As shown previously in table 5, the aggregate  actual results through the end of 2009 for resources showed a total of  $188.4 billion, or 4 percent more than GAO’s pro rata estimated $181.5  billion in the stress test’s more adverse scenario. Eleven of the 19 BHCs  tracked greater than the pro rata estimated amount in 2009, while the  remaining 8 tracked less than the estimate (see figure 11). GMAC and  MetLife, Inc. had negative resources in 2009, although only GMAC was  projected to have negative resources over the full 2-year period.
Our calculation considers increases in ALLL during 2009 to be a drain on  resources in order to mirror the regulators’ calculation for the full 2-year  projection. However, the ALLL may ultimately be used as a resource in  2010, causing available resources to be higher than they currently appear  in our tracking. PPNR is based on numerous factors, including interest  income, trading revenues, and expenses. The future course of this  resource will be affected by factors such as the performance of the general  economy, the BHCs’ business strategies, and regulatory changes, including  the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010  (Dodd-Frank Act) and the Credit Card Accountability, Responsibility, and  Disclosure Act of 2009. Such regulatory changes could impose additional  costs or reduce future profitability, either of which would impact future  PPNR.
section_title: SCAP Provided Lessons That Could Help Regulators Strengthen Supervisory Oversight and BHCs Improve Risk Management Practices
paragraphs: The SCAP stress test provided lessons in a number of areas that can be  incorporated in the bank supervision process and used to improve BHCs’  risk management practices. First, the transparency that was part of SCAP  helped bolster market confidence, but the Federal Reserve has not yet  developed a plan that incorporates transparency into the supervisory  process. Second, the SCAP experience highlighted that BHCs’ stress tests  in the past were not sufficiently comprehensive and we found that  regulators’ oversight of these tests has been generally weak. Third, we  identified opportunities to enhance both the process and data inputs for  conducting stress testing in the future. Finally, SCAP demonstrated the  importance of robust coordination and communication among the  different regulators as an integral part of any effective supervisory  process. By incorporating these lessons going forward, regulators will be  able to enhance their ability to efficiently and effectively oversee the risk- taking in the banking industry.
subsections: section_title: SCAP’s Transparency Helped Bolster Market Confidence, but the Federal Reserve Has Yet to Implement a Plan to Incorporate Greater Transparency into the Supervisory Process
paragraphs: As stated earlier and as agreed generally by market participants, the public  release of the SCAP design and results helped restore confidence in the  financial system during a period of severe turmoil. Some agency officials  stated that their experience in implementing SCAP suggested that greater  transparency would also be beneficial in the supervisory process. In recent  statements, the chairman and a governor of the Federal Reserve have both  stated that, while protecting the confidentiality of firm-specific proprietary  information is imperative, greater transparency about the methods and  conclusions of future stress tests could benefit from greater scrutiny by  the public. The Federal Reserve governor also noted that feedback from  the public could help to improve the methodologies and assumptions used  in the supervisory process. In addition, they noted that more transparency  about the central bank’s activities overall would ultimately enhance  market discipline and that the Federal Reserve is looking at ways to  enhance its disclosure policies.
Consistent with the goal of greater transparency, we previously  recommended that the Federal Reserve consider periodically disclosing to  the public the aggregate performance of the 19 BHCs against the SCAP  estimates for the 2-year forecast period. Subsequently, the chairman and  a governor of the Federal Reserve have publicly disclosed 2009 aggregate  information about the performance of the 19 BHCs based on the Federal  Reserve’s internal tracking. As the 2-year SCAP period comes to a close at  the end of 2010, completing a final analysis that compares the performance  of BHCs with the estimated performance under the more adverse  economic scenario would be useful; however, at the time of the review,  Federal Reserve officials told us that they have not decided whether to  conduct and publicly release any type of analysis. Given that the chairman  and a governor of the Federal Reserve have already publicly disclosed  some aggregate BHC performance against the more adverse scenario for  2009, providing the   2-year results would provide the public with consistent and reliable  information from the chief architect of the stress test that could be used to  further establish the importance of understanding such tests and consider  lessons learned about the rigor of the stress test estimates.
Increasing transparency in the bank supervisory process is a more  controversial issue to address. Supervisory officials from OCC (including  the then Comptroller) and the Federal Reserve question the extent to  which greater transparency would improve day-to-day bank supervision.  And, some BHCs we interviewed also were against public disclosure of  future stress tests results. They noted that SCAP was a one-time stress test  conducted under unique circumstances. Specifically, during the financial  crisis, Treasury had provided a capital backstop for BHCs that were  unable to raise funds privately. They expressed concern that public  disclosure of certain unfavorable information about individual banks in a  normal market environment could cause depositors to withdraw funds en  masse creating a “run” on the bank. In addition, banks that appear weaker  than their peers could be placed at a competitive disadvantage and may  encourage them to offer more aggressive rates and terms for new  depositors, thereby increasing their riskiness and further affecting their  financial stability. While these concerns are valid and deserve further  consideration, they have to be weighed against the potential benefits of  greater transparency about the financial health of financial institutions and  the banking system in general to investors, creditors, and counterparties.
The Dodd-Frank Act takes significant steps toward greater transparency.  For example, the act requires the Federal Reserve to perform annual stress  tests on systematically significant institutions and publicly release a  summary of results. Also, the act requires each of the systematically  significant institutions to publicly report the summary of internal stress  tests semiannually. Given comments by its senior leadership, the Federal  Reserve is willing to engage in a constructive dialogue about creating a  plan for greater transparency that could benefit the entire financial sector.  The other federal bank regulators—FDIC, OCC, and the Office of the  Thrift Supervision—are also critical stakeholders in developing such a  plan. While Federal Reserve officials have discussed possible options for  increasing transparency, the regulators have yet to engage in a formal  dialogue about these issues and have not formalized a plan for the public  disclosure of regulatory banking information or developed a plan for  integrating public disclosures into the ongoing supervisory process.  Without a plan for reconciling these divergent views and for incorporating  steps to enhance transparency into the supervisory process and practices,  including the public disclosure of certain information, bank regulators  may miss a significant opportunity to enhance market discipline by  providing investors, creditors, and counterparties with information such  as bank asset valuations.
section_title: Limited Use and Weak Oversight of BHCs’ Stress Tests Prior to SCAP Highlights the Need for More Rigorous Testing and Better Monitoring of Tests
paragraphs: SCAP highlighted that the development and utilization of BHCs’ stress  tests were limited. Further, BHC officials noted that they failed to  adequately stress test for the effects of a severe economic downturn  scenario and did not test on a firmwide basis or test frequently enough. We  also found that the regulator’s oversight of these tests were weak,  reinforcing the need for more rigorous and firmwide stress testing, better  risk governance processes by BHCs, and more vigorous oversight of BHCs’  stress tests by regulators. Going forward, as stress tests become a  fundamental part of oversights of individual banks and the financial  system, more specific guidance needs to be developed for examiners.  BHCs and regulators stated that they are taking steps to address these  shortcomings.
subsections: section_title: BHCs Generally Did Not Perform Firmwide Stress Tests Prior to SCAP
paragraphs: Prior to SCAP, many BHCs generally performed stress tests on individual  portfolios, such as commercial real estate or proprietary trading, rather  than on a firmwide basis. SCAP led some institutions to look at their  businesses in the aggregate to determine how losses would affect the  holding company’s capital base rather than individual portfolios’ capital  levels. As a result, some BHC officials indicated that they had begun  making detailed assessments of their capital adequacy and risk  management processes and are making improvements. Officials from one  BHC noted that before SCAP their financial and risk control teams had run  separate stress tests, but had not communicate or coordinate with each  other about their stress testing activities. Officials from another BHC  noted that their senior management and board of directors were not  actively involved in the oversight of the stress testing process. These  officials said that since participating in SCAP, they have improved in these  areas by institutionalizing the internal communication and coordination  procedures between the financial risk and control teams, and by  increasing communication with senior management and board of directors  about the need for active involvement in risk management oversight,  respectively. These improvements can enhance the quality of the stress  testing process. Moreover, officials of BHCs that were involved in ongoing  bank mergers during the SCAP process credited SCAP with speeding up of  the conversion process of the two institutions’ financial systems since the  BHCs’ staff had to work together to be able to quickly provide, among  other things, the aggregate asset valuations and losses of the combined  firm’s balance sheets to the regulators.
BHC officials also stated that their stress tests would take a firmwide  view, that is, taking into account all business units and risks within the  holding company structure and would include updates of the economic  inputs used to determine potential losses and capital needs in adverse  scenarios. One BHC noted that it had developed several severe stress  scenarios for liquidity because the recent financial crisis had shown that  liquidity could deteriorate more quickly than capital, endangering a  company’s prospects for survival. This danger became evident in the  failures of major financial institutions during the recent financial crisis— for example, IndyMac Bank, Lehman Brothers, and Bear Stearns.
section_title: BHCs Did Not Sufficiently Stress Their Portfolios for Unexpected Losses Prior to SCAP
paragraphs: Officials from many SCAP BHCs and the Federal Reserve noted that  internal bank stress test models generally did not use macroeconomic  assumptions and loss rates inputs as conservative as those used in the  SCAP stress test. According to Federal Reserve officials, using the SCAP  macroeconomic assumptions, most of the 19 BHCs that took part in SCAP  initially determined that they would not need additional capital to weather  the more adverse scenario. However, the SCAP test results subsequently  showed that more than half of them (10 of 19) did need to raise capital to  meet the SCAP capital buffer requirements. Some BHCs indicated that  future stress tests would be more comprehensive than SCAP. BHCs can  tailor their stress test assumptions to match their specific business  models, while SCAP generally used a one-size-fits-all assumptions  approach. For example, some BHCs noted that they use macroeconomic  inputs (such as disability claims, prolonged stagflation, or consumer  confidence) that were not found in the SCAP stress test.
Although the Federal Reserve has required BHCs to conduct stress tests  since 1998, officials from several BHCs noted that their institutions had  not conducted rigorous stress tests in the years prior to SCAP, a statement  that is consistent with regulatory findings during the same period. To some  degree, this lack of rigorous testing reflected the relatively good economic  times that preceded the financial crisis. According to one credit rating  agency and a BHC, stress test assumptions generally tend to be more  optimistic in good economic times and more pessimistic in bad economic  times. In addition, one BHC noted that it had conducted stress tests on and  off for about 20 years, but usually only as the economy deteriorated. To  address this issue, many BHC officials said that they have incorporated or  are planning to incorporate more conservative inputs into their stress test  models and are conducting more rigorous, firmwide stress testing more  frequently.
section_title: Regulators Required Stress Tests Prior to SCAP, but Oversight Was Limited
paragraphs: Although regulators’ guidelines have required for over 10 years that  financial institutions use stress tests to assess their capacity to withstand  losses, we found that regulators’ oversight of these tests had been limited.  Horizontal examinations by the regulators from 2006 through 2008  identified multiple weaknesses in institutions’ risk management systems,  including deficiencies in stress testing. Areas of weaknesses found during  examination included that the BHCs’ stress testing of their balance sheets  lacked severity, were not performed frequently enough, and were not done  on a firmwide basis. Also, it was found that BHCs’ risk governance process  lacked the active and effective involvement of BHC senior management  and board of directors. The SCAP stress test and the financial crisis  revealed the same shortcomings in BHCs’ risk management and stress  testing practices.
However, we previously found that regulators did not always effectively  address these weaknesses or in some cases fully appreciate their  magnitude. Specifically, regulators did not take measures to push  forcefully for institutions to better understand and manage risks in a  timely and effective manner. In addition, according to our discussions with  some SCAP participants, oversight of these tests through routine  examinations was limited in scope and tended to be discretionary. For  example, regulators would review firms’ internal bank stress tests of  counterparty risk and would make some suggestions, but reviews of these  tests were done at the discretion of the individual supervisory team and  were not consistently performed across teams. Even though BHCs have  for many years performed stress tests to one degree or another, they have  not been required to report the results of their testing to the Federal  Reserve unless it specifically requested the information.
The Federal Reserve recently issued a letter to the largest banking  organizations outlining its view on good practices with respect to the use  of stress testing in the context of internal capital adequacy assessment  practices (ICAAP). For example, some areas highlighted in the letter  include how frequent a stress test should be performed, the minimum time  frame that the test should cover, documentation of the process,  involvement of senior management and board of directors, and types of  scenarios and risks to include in such tests. Some BHC officials believed  that stress testing would become an integral part of future risk  management practices and noted that SCAP helped them see how bank  examiners would want them to stress their portfolios in the future. In  anticipation of future action by regulators, many BHCs were designing at  least part of their stress tests along the lines of SCAP. However, a few BHC  officials hoped that future stress tests would not be performed in the same  manner as SCAP, with the largest institutions tested simultaneously in a  largely public setting, but rather as part of the confidential supervisory  review process.
section_title: Regulatory Oversight Is to Focus on More Rigorous Stress Testing, but Examiners Need More Specific Guidance
paragraphs: Federal Reserve officials stated that going forward, stress tests will  become a fundamental part of the agency’s oversight of individual banks  and the financial system. As a result of SCAP, Federal Reserve officials  stated that they are placing greater emphasis on the BHCs’ internal capital  adequacy planning through their ICAAP. This initiative is intended to  improve the measurement of firmwide risk and the incorporation of all  risks into firms’ capital planning assessment and planning processes. In  addition to enhanced supervisory focus on these practices across BHCs,  stress testing is also a key component of the Basel II capital framework  (Pillar 2). Under Pillar 2, supervisory review is intended to help ensure  that banks have adequate capital to support all risks and to encourage that  banks develop and use better risk management practices. All BHCs,  including those adopting Basel II, must have a rigorous process of  assessing capital adequacy that includes strong board and senior  management oversight, comprehensive assessment of risks, rigorous  stress testing and scenario analyses, validation programs, and independent  review and oversight. In addition, Pillar 2 requires supervisors to review  and evaluate banks’ internal capital adequacy assessments and monitor  compliance with regulatory capital requirements. The Federal Reserve  wants the large banks to conduct this work for themselves and report their  findings to their senior management and boards of directors. According to  Federal Reserve officials, for BHCs to satisfy the totality of expectations  for ICAAP it may take 18 to 24 months, partly because the BHCs are taking  actions to enhance practices where needed—including with respect to the  use of stress testing and scenario analyses in internal capital  assessments—and the Federal Reserve then needs to evaluate these  actions across a relatively large number of BHCs.
In addition, the Federal Reserve is finalizing guidance for examiners to  assess the capital adequacy process, including stress testing, for BHCs.  Examiners are expected to evaluate how BHCs’ stress tests inform the  process for identifying and measuring risk and decisions about capital  adequacy. Federal Reserve officials stated that examiners are expected to  look closely at BHCs’ internal stress test methodologies and results. In a  letter to BHCs, the Federal Reserve also emphasized that institutions  should look at time frames of 2 or more years and considers losses  firmwide. It also suggested that BHCs develop their own stress test  scenarios and then review these scenarios and the results for appropriate  rigor and quantification of risk.
While these are positive steps, examiners do not have specific criteria for  assessing the quality of these tests. For example, the Federal Reserve has  not established criteria for assessing the severity of the assumptions used  to stress BHCs’ balance sheets. The Federal Reserve officials stated that  they intend to have technical teams determine the type of criteria that will  be needed to evaluate these assumptions, but they are in the early  planning stages. Development of such criteria will be particularly helpful  in ensuring the effective implementation of the stress test requirements  under the Dodd-Frank Act. Without specific criteria, Federal Reserve  examiners will not be able to ensure the rigor of BHCs’ stress tests—an  important part of the capital adequacy planning. Furthermore, the absence  of such guidance could lead to variations in the intensity of these  assessments by individual examiners and across regional districts.
section_title: Risk Identification and Assessment Infrastructure Needs to be Upgraded to Improve Oversight
paragraphs: Following SCAP, regulatory and BHC officials we met with identified  opportunities to enhance both the process and data inputs for conducting  stress testing in the future. This would include processes for obtaining,  analyzing, and sharing data and capabilities for data modeling and  forecasting, which potentially could increase the Federal Reserve’s  abilities to assess risks in the banking system. According to the Federal  Reserve, an essential component of this new system will be a quantitative  surveillance mechanism for large, complex financial institutions that will  combine a more firmwide and multidisciplinary approach for bank  supervision. This quantitative surveillance mechanism will use supervisory  information, firm-specific data analysis, and market-based indicators to  identify developing strains and imbalances that may affect multiple  institutions, as well as emerging risks within specific institutions. This  effort by the Federal Reserve may also improve other areas of supervision  which rely on data and quantitative analysis, such as assessing the process  used by BHC’s to determine their capital adequacy, forecasting revenue,  and assessing and measuring risk, which is critical to supervising large,  complex banks. Officials at the Federal Reserve told us that examiners  should be analyzing BHC performances versus their stress test projections  to provide insight into the agency’s loss forecasting approach. Moreover,  Federal Reserve officials stated that they are always looking to increase  their analytical capabilities, and they have recently implemented a new  governance structure to address some of their management information  infrastructure challenges. However, not enough time has passed to  determine the extent to which such measures will improve banking  supervision.
In addition, some other deficiencies were found in the data reported to the  Federal Reserve by BHCs using the Y-9C, as well as the Federal Reserve’s  ability to analyze the risk of losses pertaining to certain portfolios that  were identified during the SCAP stress test. This led the Federal Reserve  to develop a more robust risk identification and assessment infrastructure  including internally developed models or purchased analytical software  and tools from data vendors. Going forward, such models and analytics  would facilitate improved risk identification and assessment capabilities  and oversight, including the oversight of systemic risk. Moreover, a risk  identification and assessment system that can gauge risk in the banking  sector by collecting data on a timelier basis is necessary to better ensure  the safety and soundness of the banking industry. Specific areas in which  data collection and risk identification and assessment could be enhanced  include mortgage default modeling to include more analysis of  nontraditional mortgage products, counterparty level exposures, country  and currency exposures, and commodity exposures. An example of where  the Federal Reserve used SCAP to significantly upgrade its ability to  assess risks across large BHCs is the development of a system that  allowed BHCs to submit their securities positions and market values at a  fixed date and apply price shocks. This process was enhanced during  SCAP to facilitate the stress analysis of securities portfolios held by SCAP  BHCs. This system allowed the Federal Reserve to analyze approximately   100,000 securities in a relatively short time period. The Federal Reserve  intends to continue using this database to receive and analyze updated  positions from BHCs.
With other portfolios, the Federal Reserve contracted with outside data  and analytical systems providers. For multifamily loan portfolios, nonfarm  loans, and nonresidential loans with a maturity beyond 2 years, all of  which are subsets of commercial and industrial loans or commercial real  estate portfolios, the Federal Reserve used internal models and purchased  an outside vendor service that allowed it to estimate losses for these  portfolios. For the remaining commercial portfolios, the Federal Reserve  used different existing models found at both the Federal Reserve and  Federal Reserve district banks and new models developed to meet the  needs of SCAP. When analyzing BHCs’ mortgage portfolios, the consumer  loans Supervisory Analytical and Advisory Team provided templates to the  BHCs to collect granular data for such analysis, allowing the system to  separate BHCs’ mortgage portfolios into much more granular tranches  than would be possible using data from regulatory filings. The Federal  Reserve further used data from various sources, including a large  comprehensive loan-level database of most mortgages that have been  securitized in the United States to assist in developing its own loss  estimates to benchmark against the BHCs’ proprietary estimates.
These examples point to enhancements in the ability to assess risks to  individual firms and across the banking sector that resulted from the SCAP  stress test. The Federal Reserve has made clear that it views many of these  innovations in its ability to assess and model risks and potential losses as  permanent additions to its toolkit, and has also recognized the need for  more timely and granular information to improve its supervision of BHCs  and other institutions. However, the extent to which these models and  tools will be distributed across the Federal Reserve district banks and  other federal banking regulators is unclear. In addition, as the stress test  applied to trading positions was limited to those BHCs that held trading  positions of at least $100 billion as of February 20, 2009, the Federal  Reserve has not indicated that it will roll out its new system to BHCs with  smaller trading positions. The Federal Reserve has taken steps to maintain  and enhance the tools and data used during SCAP. Further, improving the  Federal Reserve’s financial data collection and supervisory tools will  require additional resources, training for bank examiners, coordination in  the dissemination of new infrastructure across all U.S. financial regulators,  and, according to a Federal Reserve governor, would benefit from relief  from the Paperwork Reduction Act of 1980 as well.
The Federal Reserve lacks a complete plan on how it will achieve  permanent improvements in its risk identification and assessment  infrastructure, but according to officials, such a plan is in development.  The Federal Reserve has finalized a plan that describes a governance  structure for overseeing large, complex financial organizations. The plan  defines the roles and responsibilities of various committees and teams  within the Federal Reserve that will carry out its supervisory  responsibilities over these organizations. However, further planning is  needed to incorporate lessons learned from SCAP for addressing data and  modeling gaps that existed prior to the crisis and a structure for  disseminating improvements to risk identification and assessment.  Specifically, this plan will also be critical to addressing improvements to  data and modeling infrastructure in supervising not only large financial  holding companies but also smaller institutions. A fully developed plan  would also consider how to disseminate data, models, and other  infrastructure to the entire Federal Reserve System and bank regulatory  agencies, as well as the newly established Financial Stability Oversight  Council and Treasury’s Office of Financial Research. Without such a plan,  the agency runs the risk of not optimizing its oversight responsibilities,  especially in light of its new duties as the systemic risk regulator under the  Dodd-Frank Act.
section_title: More Coordination and Communication across Regulators Is Critical for Understanding Risks to Individual Institutions and Financial Markets
paragraphs: Another critical lesson from SCAP was the need for robust coordination  and communication among the regulators in examining large, complex  financial institutions. Officials from the regulatory agencies and BHCs  stated that the degree of cooperation among the SCAP regulators was  unprecedented and improved the understanding of the risks facing the  individual BHCs and the financial market. Such coordination and  communication will become increasingly important as banking regulators  increase their oversight role. Even with recent major reform to the  financial regulatory structure, multiple regulatory agencies continue to  oversee the banking industry, and regulators will need to prioritize efforts  to promote coordination and communication among staff from these  agencies so that emerging problematic issues affecting the financial  industry are identified in a timely manner and effectively addressed.
Going forward, based on our discussions with various SCAP participants  and statements by Federal Reserve officials, including the chairman, the  regulators’ experience with SCAP is anticipated to lead to the expanded  use of horizontal examinations and multidisciplinary staff that will require  extensive interagency coordination. Horizontal examinations may involve  multiple regulators and underscore the importance of effective  coordination and communication.
Currently, regulators are conducting horizontal examinations of internal  processes that evaluate the capital adequacy at the 28 largest U.S. BHCs.  Their focus is on the use of stress testing and scenario analyses in ICAAP,  as well as how shortcomings in fundamental risk management practices  and governance and oversight by the board of directors for these  processes could impair firms’ abilities to estimate their capital needs.  Regulators recently completed the initial phase of horizontal examinations  of incentive compensation practices at 25 large U.S. BHCs. As part of this  review, each organization was required to submit an analysis of  shortcomings or “gaps” in its existing practices relative to the principles  contained in the proposed supervisory guidance issued by the Federal  Reserve in the fall of 2009 as well as plans—including timetables—for  addressing any weaknesses in the firm’s incentive compensation  arrangements and related risk-management and corporate governance  practices. In May 2010, regulators provided the banking organizations  feedback on the firms’ analyses and plans. These organizations recently  submitted revised plans to the Federal Reserve for addressing areas of  deficiencies in their incentive compensation programs. In a June 2010  press release, the Federal Reserve noted that to monitor and encourage  improvements in compensation practices by banking organizations, its  staff will prepare a report after 2010 on trends and developments in such  practices at banking organizations.
Our prior work has found that coordination and communication among  regulatory agencies is an ongoing challenge. For example, in 2007, OCC  onsite examiners, as well as officials in headquarters, told us that  coordination issues hampered the Federal Reserve’s horizontal  examinations. Also, in 2007, a bank told us that it had initially received  conflicting information from the Federal Reserve, its consolidated  supervisor, and the OCC, its primary bank supervisor, regarding a key  policy interpretation. Officials from the bank also noted that when the  Federal Reserve collected information, it did not coordinate with OCC, the  primary bank examiner of the lead bank, resulting in unnecessary  duplication. We noted that to improve oversight in the future, regulators  will need to work closely together to expedite examinations and avoid  such duplications.
Since the SCAP stress test was concluded, the following examples  highlight ongoing challenges in coordination and communication:    Officials from OCC and FDIC indicated that they were not always involved  in important discussions and decisions. For example, they were not  involved in the decision to reduce GMAC’s SCAP capital requirement, even  though they were significantly involved in establishing the original capital  requirement. Also, FDIC noted that it was excluded from such decision  even though it is the primary federal bank regulator for GMAC’s retail  bank (Ally Bank).
The Federal Reserve held an internal meeting to discuss lessons learned  from SCAP, but has yet to reach out to the other SCAP regulators. The  OCC and FDIC told us that they had not met with the Federal Reserve as a  group to evaluate the SCAP process and document lessons learned. As a  result, the FDIC and OCC did not have an opportunity to share their views  on what aspects of SCAP worked and did not work, as well as any  potential improvements that can be incorporated into future horizontal  reviews or other coordinated efforts.
In the recent horizontal examinations, both FDIC and OCC noted that the  interagency process for collaboration—especially in the initial design  stages—was not as effective as it was for SCAP. OCC commented that  more collaboration up front would have been preferable. Also, FDIC  stated that the Federal Reserve did not include it in meetings to formulate  aggregate findings for the horizontal examination of incentive  compensation programs, and it experienced difficulties in obtaining  aggregate findings from the Federal Reserve. The Federal Reserve  commented that the FDIC was involved in the development of findings for  those organizations that control an FDIC-supervised subsidiary bank and  that FDIC has since been provided information on the findings across the  full range of organizations included in the horizontal review, the majority  of which do not control an FDIC-supervised subsidiary bank.
These continued challenges in ensuring effective coordination and  communication underscore the need for sustained commitment and effort  by the regulators to ensure the inclusion of all relevant agencies in key  discussions and decisions regarding the design, implementation, and  results of multiagency horizontal examinations. As the SCAP process has  shown, active participation by all relevant regulators can strengthen  approaches used by examiners in performing their supervisory activities.  Without continuous coordination and communication, the regulators will  miss opportunities to leverage perspectives and experiences that could  further strengthen the supervision of financial institutions, especially  during horizontal examinations of financial institutions.
section_title: Conclusions
paragraphs: Publicly reporting a comparison of the actual performance of the SCAP  BHCs and the estimated performance under a more adverse scenario  provides insights into the financial strength of the nation’s largest BHCs.  Senior Federal Reserve officials have publicly disclosed select aggregate  information about the performance of the 19 BHCs consistent with the  recommendation in our June 2009 report. Specifically, we recommended  that the Federal Reserve consider periodically disclosing to the public the  performance of the 19 BHCs against the SCAP estimates during the 2-year  period. However, the Federal Reserve has yet to commit to completing a  final analysis that compares the BHCs’ actual performance with the  estimated performance under SCAP’s more adverse economic scenario for  the entire 2-year period and making this analysis public. Such an analysis  is important for the market and BHCs to assess the rigor of the stress test  methodology. Publicly releasing the results also would allow the public to  gauge the health of the BHCs that participated in SCAP, which is a strong  proxy for the entire U.S. banking industry. And public disclosure of this  analysis could act as a catalyst for a public discussion of the value of  effective bank risk management and enhance confidence in the regulatory  supervision of financial institutions.
The public release of the stress test methodology and results helped  improve market confidence in the largest BHCs during the recent financial  crisis and provided an unprecedented window into bank supervision  process. Subsequently, the Chairman of the Federal Reserve and a Federal  Reserve governor have publicly stated that greater transparency should be  built into the supervisory process and that feedback from the public could  help increase the integrity of the supervisory process. Increased  transparency can also augment the information that is available to  investors and counterparties of the institutions tested and enhance market  discipline. Despite these statements, the Federal Reserve and other bank  regulators have yet to start a formal dialogue about this issue, nor have  they developed a plan for integrating public disclosures into the ongoing  supervisory process. Such a plan could detail the types of information that  would benefit the markets if it were publicly released; the planned  methodology for the stress tests, including assumptions; the frequency  with which information would be made public; and the various means of  disseminating the information. Taking into account the need to protect  proprietary information and other market-sensitive information would be  an important part of such a plan. While regulators will undoubtedly face  challenges in determining how best to overcome skepticism about the  potential effects on the financial markets of disclosing sensitive  information on the financial health of banks, the Dodd-Frank Act requires  that the Federal Reserve and certain banks publicly release a summary of  results from periodic stress tests. Without a plan for enhancing the  transparency of supervisory processes and practices, bank regulators may  miss a significant opportunity to further strengthen market discipline and  confidence in the banking industry by providing investors, creditors, and  counterparties with useful information.
The SCAP stress test shed light on areas for further improvement in the  regulators’ bank supervision processes, including oversight of risk  management practices at BHCs. Prior to SCAP, regulatory oversight of  stress tests performed by the BHCs themselves was ineffective.  Specifically, although regulators required stress tests, the guidelines for  conducting them were more than a decade old, and the individual banks  were responsible for designing and executing them. The Federal Reserve’s   reviews of the internal stress tests were done at the discretion of the  BHCs’ individual supervisory teams and were not consistently performed.  Further, even though BHCs performed stress tests, they were not required  to report the results of their stress testing to the Federal Reserve without a  specific request from regulators. Post-SCAP, however, the Federal Reserve  has stated that stress testing will now be a fundamental part of their  oversight of individual banks. The Federal Reserve expects to play a more  prominent role in reviewing assumptions, results, and providing input into  the BHCs’ risk management practices. While the Federal Reserve has  begun to take steps to augment its oversight, currently Federal Reserve  examiners lack specific criteria for assessing the severity of BHCs’ stress  tests. Without specific criteria, Federal Reserve examiners will not be able  to ensure the rigor of BHCs’ stress tests. Furthermore, the absence of such  criteria could lead to variations in the intensity of these assessments by  individual examiners and across regional districts.
The experience with SCAP also showed that regulators needed relevant  and detailed data to improve oversight of individual banks and to identify  and assess risks. As the Federal Reserve and the other regulators conduct  more horizontal reviews, they will need a robust plan for quantitatively  assessing the risk in the banking sector. Collecting timely data for the  annual stress testing and other supervisory actions will be critical in order  to better ensure the safety and soundness of the banking industry. The  Federal Reserve has finalized a plan that describes a governance structure  for overseeing large, complex financial organizations. However, further  planning is needed to incorporate lessons learned from SCAP for  addressing data and modeling gaps and a structure for disseminating  improvements to risk identification and assessment. Further, efforts to  improve the risk identification and assessment infrastructure will need to  be effectively coordinated with other regulators and the newly established  Financial Stability Oversight Council and Treasury’s Office of Financial  Research in order to ensure an effective systemwide risk assessment.  Without fully developing a plan that can identify BHCs’ risks in time to  take appropriate supervisory action, the Federal Reserve may not be well- positioned to anticipate and minimize future banking problems and ensure  the soundness of the banking system.
Despite the positive coordination and communication experience of the  SCAP stress test, developments since the completion of SCAP have  renewed questions about the effectiveness of regulators’ efforts to  strengthen their coordination and communication. For example, on  important issues, such as finalizing GMAC’s SCAP capital amount, the  Federal Reserve chose not to seek the views of other knowledgeable bank  regulators. While the Dodd-Frank Act creates formal mechanisms that  require coordination and communication among regulators, the  experiences from SCAP point to the need for a sustained commitment by  each of the banking regulators to enhance coordination and  communication. In particular, ensuring inclusion of relevant agencies in  key discussions and decisions regarding the design, implementation, and  results of multiagency horizontal examinations will be critical. If  regulators do not consistently coordinate and communicate effectively  during horizontal examinations, they run the risk of missing opportunities  to leverage perspectives and experiences that could further strengthen  bank supervision.
section_title: Recommendations
paragraphs: To gain a better understanding of SCAP and inform the use of similar  stress tests in the future, we recommend that the Chairman of the Federal  Reserve direct the Division of Banking Supervision and Regulation to:    Compare the performance of the 19 largest BHCs against the more adverse  scenario projections following the completion of the 2-year period covered  in the SCAP stress test ending December 31, 2010, and disclose the results  of the analysis to the public.
To leverage the lessons learned from SCAP to the benefit of other  regulated bank and thrift institutions, we recommend that the Chairman of  the Federal Reserve in consultation with the heads of the FDIC and OCC  take the following actions:    Follow through on the Federal Reserve’s commitment to improve the  transparency of bank supervision by developing a plan that reconciles the  divergent views on transparency and allows for increased transparency in  the regular supervisory process. Such a plan should, at a minimum, outline  steps for releasing supervisory methodologies and analytical results for  stress testing.
Develop more specific criteria to include in its guidance to examiners for  assessing the quality of stress tests and how these tests inform BHCs’  capital adequacy planning. These guidelines should clarify the stress  testing procedures already incorporated into banking regulations and  incorporate lessons learned from SCAP.
Fully develop its plan for maintaining and improving the use of data, risk  identification and assessment infrastructure, and requisite systems in  implementing its supervisory functions and new responsibilities under the  Dodd-Frank Act. This plan should also ensure the dissemination of these  enhancements throughout the Federal Reserve System and other financial  regulators, as well as new organizations established in the Dodd-Frank  Act.
Take further steps to more effectively coordinate and communicate among  themselves. For example, ensuring that all applicable regulatory agencies  are included in discussions and decisions regarding the development,  implementation, and results of multiagency activities, such as horizontal  examinations of financial institutions.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided a draft of this report to the Federal Reserve, FDIC, OCC,  OTS, and Treasury for review and comment. We received written  comments from the Chairman of the Federal Reserve Board of Governors  and the Assistant Secretary for Financial Stability. These comments are  summarized below and reprinted in appendixes IV and V, respectively. We  also received technical comments from the Federal Reserve, FDIC, OCC,  and Treasury, which we incorporated into the report as appropriate. OTS  did not provide any comments. In addition, we received technical  comments from the Federal Reserve and most of the 19 SCAP BHCs on the  accuracy of our tracking of revenues and losses in 2009 for each of the  SCAP BHCs and incorporated them into the report as appropriate.
In its comment letter, the Federal Reserve agreed with all five of our  recommendations for building on the successes of SCAP to improve bank  supervision. The Federal Reserve noted that our recommendations  generally relate to actions it is currently undertaking or planning to take  under the Dodd-Frank Act. It also cited that in coordination with FDIC and  OCC, it would provide a public assessment of BHCs’ performance relative  to the loss and preprovision net revenue estimates under the more adverse  scenario, taking into account the limitations of such an analysis. For our  remaining recommendations related to increased transparency, examiner  guidance, risk identification and assessment, and coordination and  communication of multiagency activities, the Federal Reserve generally  noted that it has taken step in these areas and will continue to consult  with the FDIC and OCC in implementing our recommendations and its  new responsibilities under the Dodd-Frank Act.
While our report recognizes the steps that the Federal Reserve has taken  related to transparency, examiner guidance, risk identification and  assessment, and coordination and communication of multiagency  activities, these areas warrant ongoing attention. For example, as we note  in the report, while the Federal Reserve is in the process of finalizing  examination guidance for reviewing stress tests, examiners currently do  not have specific criteria for assessing the severity of these tests nor have  they coordinated with the other bank regulators. Until this guidance is  completed, examiners will lack the information needed to fully ensure the  rigor of BHCs’ stress tests, and the Board will not be able to fully ensure  the consistency of the assessment by individual examiners. Our report also  notes the positive coordination and communication experience of the  SCAP stress test, but we continued to find specific instances since the  completion of SCAP that have renewed questions about the effectiveness  of regulators’ efforts to strengthen their coordination and communication.  For instance, while the Federal Reserve included relevant agencies in key  discussions and decisions regarding the design, implementation, and  results of SCAP, we found that the Federal Reserve missed opportunities  to include other bank regulators when planning more recent horizontal  examinations.
Treasury agreed with our report findings, noting that it appreciated our  acknowledgment that SCAP met its goals of providing a comprehensive,  forward-looking assessment of the balance sheet risks of the largest banks  and increasing the level and quality of capital held by such banks. It  further noted that the unprecedented public release of the stress test  results led to an increase in the market confidence in the banking system,  which aided in improving the capital adequacy of the largest banks.
We are sending copies of this report to the appropriate congressional  committees; Chairman of the Federal Reserve, the Acting Comptroller of  Currency, Chairman of the FDIC, the Acting Director of the Office of the  Thrift Supervision, and the Secretary of the Treasury. Also, we are sending  copies of this report to the Congressional Oversight Panel, Financial  Stability Oversight Board, the Special Inspector General for TARP, and  other interested parties. In addition, the report will be available at no  charge on the GAO Web site at http://www.gao.gov.
Should you or your staff have any questions on the matters discussed in  this report, please contact me at (202) 512-8678 or williamso@gao.gov.  Contact points for our Offices of Congressional Relations and Public  Affairs may be found on the last page of this letter. GAO staff who made  key contributions to this report are listed in   appendix VI.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of this report were to (1) describe the process used to  design and conduct the stress test and participants views’ of the process,  (2) describe the extent to which the stress test achieved its goals and  compare its estimates with the bank holding companies’ (BHC) actual  results, and (3) identify the lessons regulators and BHCs learned from the  Supervisory Capital Assessment Program (SCAP) and examine how each  are using those lessons to enhance their risk identification and assessment  practices.
To meet the report’s objectives, we reviewed the Board of Governors of  the Federal Reserve System’s (Federal Reserve) The Supervisory Capital  Assessment Program: Design and Implementation (SCAP design and  implementation document) dated April 24, 2009, and The Supervisory  Capital Assessment Program: Overview of Results (SCAP results  document) dated May 7, 2009. We analyzed the initial stress test data that  the Federal Reserve provided to each BHC, the subsequent adjustments  the Federal Reserve made to these estimates, and the reasons for these  adjustments. We reviewed BHC regulatory filings such as the Federal  Reserve’s 2009 Consolidated Financial Statements for Bank Holding  Companies—-FR Y-9C (Y-9C); company quarterly 10-Qs and annual 10-Ks;  speeches and testimonies regarding SCAP and stress testing; BHCs’  presentations to shareholders and earnings reports; bank supervision  guidance issued by the Federal Reserve, Office of the Comptroller of the  Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC);  and documents regarding the impact of SCAP and the financial crisis and  proposed revisions to bank regulation and supervisory oversight. To  further understand these documents and obtain different perspectives on  the SCAP stress test, we interviewed officials from the Federal Reserve,  OCC, FDIC, and the Office of the Thrift Supervision, as well as members of  the multidisciplinary teams created to execute SCAP.
We also collected data from SNL Financial—a private financial database  that contains publicly filed regulatory and financial reports, including  those of the BHCs involved in SCAP—in order to compare the BHCs’  actual performance in 2009 against the regulators’ 2-year SCAP loss  estimates and GAO’s 1-year pro rata loss estimates. To obtain additional  background information regarding the tracking of the BHCs, perspectives  on their performance, anticipated loan losses, and the success of SCAP in  achieving its goals, we interviewed relevant officials (e.g., chief risk  officers and chief financial officers) from 11 of the 19 BHCs that  participated in the SCAP stress test. The BHCs we interviewed were the  American Express Company; Bank of America Corporation; The Bank of  New York Mellon Corporation; BB&T Corporation; Citigroup Inc.; GMAC  LLC; The Goldman Sachs Group, Inc.; JPMorgan Chase & Co.; MetLife,  Inc.; Regions Financial Corporation; and Wells Fargo & Company. We  selected these BHCs to reflect differences in size, types of financial  services provided, geographic location, primary bank regulator, and  participation in the Troubled Asset Relief Program (TARP). In addition, we  met with credit rating agency officials from the Standard and Poor’s  Corporation, Moody’s Corporation, and Fitch Ratings Inc. for their  perspective on SCAP and their own stress test practices. To more  completely understand the execution of SCAP, we completed a literature  search of stress tests conducted by others—for example, the Committee  on European Banking Supervisors and the International Monetary Fund.  We also reviewed relevant credit rating agency reports and the reports of  other oversight bodies such as the Congressional Oversight Panel and the  Special Inspector General for the Troubled Asset Relief Program on topics  related to stress testing and TARP. We also reviewed our past work on the  bank supervisory process and SCAP.
In addition, to track the actual performance of the 19 BHCs, we collected  data from several sources. We then compared the BHCs’ actual  performance to the December 31, 2008, capital levels presented in SCAP  and the projections made under the more adverse scenario for estimated  losses for loans, securities (available for sale and held to maturity), trading  and counterparty, and resources other than capital to absorb losses. Our  primary source for SCAP estimates was the May 7, 2009, SCAP results  document, which contained the estimates for each of the 19 BHCs and  aggregate data for all BHCs. We also reviewed the confidential April 24,  2009, and May 5, 2009, presentations that the SCAP regulators made to  each of the 19 BHCs to identify estimates of preprovision net revenue  (PPNR) and changes in allowance for loan and lease losses (ALLL) for the  2 years ended 2010. Our primary source for the actual results at the BHCs  was the Federal Reserve’s Y-9C. In doing so, we used the SNL Financial  database to extract data on the Y-9C and the Securities and Exchange  Commission forms 10-K and 10-Q. These data were collected following the  close of the fourth quarter of 2009, the halfway point of the SCAP’s 2-year  time frame.
Since losses were not estimated on a quarter-by-quarter or yearly basis but  projected for the full 2-year period, we assumed that losses and revenue  estimates under the more adverse scenario were distributed at a constant  rate across the projection period. Thus, we compared the actual 2009 year  end values with half of the Federal Reserve’s 2-year SCAP projections.  This methodology has some limitations because losses, expenses,  revenues, and changes to reserves are historically unevenly distributed  and loss rates over a 2-year period in an uncertain economic environment  can follow an inconsistent path. However, the Federal Reserve, OCC,  credit rating agencies, an SNL Financial analyst, and most of the BHCs we  interviewed who are tracking performance relative to SCAP estimates are  also using the same methodology. We assessed the reliability of the SNL  Financial database by following GAO’s best practices for data reliability  and found that the data was sufficiently reliable for our purposes. To  confirm the accuracy of our BHC tracking data, we shared our data with  the Federal Reserve and the 19 SCAP BHCs. We received comments and  incorporated them as appropriate.
Some of the data that we collected were not in a form that was  immediately comparable to the categories used in the SCAP results, and  we had to make adjustments in order to make the comparison. For tier 1  common capital, most asset categories, and resources other than capital to  absorb losses, we had to find a methodology suited to aggregating these  data so that we could compare it to the corresponding SCAP data. For  example, net-charge offs for the various loan categories are broken out  into more subcategories in the Y-9C than those listed in the SCAP results.  In addition, we calculated “Resources Other than Capital to Absorb  Losses” to correspond to the SCAP definition of PPNR minus the change  in ALLL, which required obtaining data from multiple entries within the Y- 9C. When calculating noninterest expense we removed the line item for  goodwill impairment losses because this item was not included in the  SCAP regulators’ projections. We also used the calculation of a change in  ALLL until December 31, 2009. But the SCAP regulators considered an  increase in ALLL over the full 2-year period to be a drain on resources,  because the provisions made to increase the ALLL balance would not be  available to absorb losses during the 2-year SCAP time frame. This notion  creates a problem in using the formula for 1-year tracking purposes  because an increase in ALLL during 2009 would require provisions for that  increase, but those added reserves could ultimately be used to absorb  losses during 2010. To maintain consistency, our calculation considers  ALLL increases during 2009 to be a drain on resources, but we recognize  that this money could act as a resource to absorb losses rather than a  drain on those resources.
We faced an additional limitation pertaining to the ALLL calculation and a  challenge with regard to the treatment of trading and counterparty  revenues. In our review of SCAP documentation, we found that SCAP  regulators used two different ALLL calculations—1 calculation for 4 of the  BHCs that included a reserve for off-balance sheet items and another for  the remaining 15 BHCs that did not include off-balance sheet reserves. The  Federal Reserve confirmed that there were two different calculations that  were not adjusted for consistency. In order to be consistent across the  BHCs, we applied the same methodology that the regulators used for 15 of  the BHCs to the 4 that remained. The treatment of trading and  counterparty revenue created a challenge because the data in the Y-9C  includes both customer derived revenue from transactions for BHCs that  operate as broker-dealers and gains (or losses) from proprietary trading  and certain associated expenses. These items are presented only in net  form in the Y-9C. However, for the five BHCs (Bank of America  Corporation; Citigroup, Inc.; Goldman Sachs Group, Inc.; JPMorgan Chase  & Co.; and Morgan Stanley) that had their trading portfolios stressed, the  trading and counterparty line is based on projections of gains (losses)  from proprietary trading, but PPNR (specifically noninterest revenue) is  based on gains from customer derived revenue from transactions for BHCs  that operate as broker-dealers. Because we could not segregate these  items based on the Y-9C, we have included the net amount in both the  trading and counterparty and noninterest income line items. This means  that the net amount of the trading gains or losses as reported in the Y-9C  are included in two places in our tracking table for those five BHCs. For  the remaining 14 BHCs, we included the entire line item in noninterest  income, as that is where it was located in the SCAP projections.
Table 6 shows the items we used to calculate tier 1 capital, asset losses,  PPNR, and ALLL as of December 31, 2009 and the specific sources we  used. We also included specific references to the sources we used. Some  elements within the table required a more detailed aggregation or  calculation and are therefore explained further in tables 7 and 8 below.  For reporting these capital measures and asset balances for the year  ending December 31, 2008, we generally relied on the figures published in  various SCAP documents.
Table 7 shows our methodology for calculating tier 1 common capital,  including the part of the Y-9C in which the data can be found. Currently,  there is no defined regulatory method for calculating tier 1 common  capital, and it is not a required data field for BHCs to file in their Y-9C  submissions. As a result, we developed a formula consistent with the  Federal Reserve’s by reviewing the guidance available in the SCAP design  and implementation and SCAP results documents and consulting with SNL  Financial regarding its methodology.
Table 8 provides a crosswalk for the asset classification we used to group  the various charge-off categories listed in the Y-9C.
To ensure additional comparability with SCAP, we attempted to identify  any unique circumstances that could skew the results. For example, after  we shared our initial tracking estimates with the 19 BHCs, one BHC had  identified an issue with our calculation of tier 1 common capital that  resulted from the way information is reported on the Y-9C. After  discussing the issue with the BHC and verifying their explanation, we  adjusted our calculation to more accurately reflect their position. Another  BHC also had a one-time charge that had been included in the “Other” loss  category, and we decided to segregate this item as a separate line item. We  have also submitted our tracking spreadsheet to the Federal Reserve and  to each BHC to give them an opportunity to provide input and ensure the  accuracy and comparability of our numbers. Appropriate adjustments to  2009 numbers based on information received from the Federal Reserve  and individual BHCs are noted, where applicable, in the tables in appendix  III.
Some items that impact precise comparisons between actual results and  the pro rata estimates are disclosed in our footnotes, rather than as  adjustments to our calculations. For example, the stress test was applied  to loan and other asset portfolios as of December 31, 2008, without  including a calculation for ongoing banking activities. Because the Y-9C  data includes ongoing activity as of the date of the report, the actual  results are slightly different than the performance of the stressed assets as  the BHCs were treated as liquidating concerns rather than going concerns  in the SCAP stress test. Distinguishing between the gains (losses) from  legacy assets and those that resulted from new assets is not possible using  public data. Other examples are that SCAP did not include the impact of  the owned debt value adjustment or one-time items (occurring subsequent  to SCAP) in their projections of PPNR. As credit default swap spreads  narrowed in 2009, liability values increased at most banks, causing a  negative impact on revenue at those banks that chose to account for their  debt at fair value; but these losses were not included in the SCAP  estimates. One-time items, such as sales of business lines, were also not  included in the SCAP estimates of PPNR, as these events occurred  subsequent to the stress test and, in part, could not be fully predicted as a  part of SCAP. Rather than remove the losses from the owned debt value  adjustments and the gains (or losses) due to one-time items from the  BHCs’ 2009 PPNR results, we disclosed the amounts in footnotes for the  applicable BHCs. We chose this treatment so that PPNR would reflect  actual results at the BHCs, while still disclosing the adjustments needed  for more precise comparability to SCAP.
We identified the TARP status of each of the 19 BHCs that participated in  SCAP by reviewing data from the Treasury’s Office of Financial Stability’s  TARP Transactions Report for the Period Ending September 22, 2010  (TARP Transactions Report) and the SCAP results document. We used the  SCAP results document to identify BHCs that were required to raise  capital. The TARP Transactions Report, was then used to identify the  program under which TARP funds were received (if any), the amount of  funds received, capital repayment date, amount repaid, and warrant  disposition date and to determine whether the warrants were repurchased  or sold by Treasury in a public offering.
To gain a better understanding of future potential losses, we determined  the percentage of BHCs’ total loans that are either nonaccrual or more  than 90 days past due using Y-9C data from the SNL Financial database.  We used quarterly data for the period 2007 through 2009 on nonaccrual  loans and past due balances of more than 90 days, for each of the BHCs.  We aggregated the data into the same six loan categories used in SCAP:  first-lien mortgages, second/junior-lien mortgages, commercial and  industrial loans, commercial real estate loans, credit card balances, and  “Other.” (See tables 8 and 9 for details.) Once the data were aggregated,  we divided that data by the applicable total loan balance for each category  at each point in time (i.e., quarterly basis). One limitation is that Y-9C data  were not available for all periods for four of the BHCs (American Express  Company; GMAC LLC; The Goldman Sachs Group, Inc.; and Morgan  Stanley) because they had recently became BHCs. As a result, we did not  include these BHCs in the calculation during those periods where their Y- 9Cs were not available (fourth quarter of 2008 and earlier for all except  GMAC LLC, which also did not have a Y-9C in the first quarter of 2009).
We collected Y-9C data from the SNL Financial database to calculate the  loan loss rates across BHCs with more than $1 billion of assets and  compare the 19 BHCs with the indicative loss rates provided by the SCAP  regulators. We used annual data for the year ended December 31, 2009, on  loan charge-offs. We also used average total loan balances. In the Y-9C  total loan balances were categorized somewhat differently from charge- offs. Table 9 provides a crosswalk for the asset classification. We  aggregated loan balance data into the same categories that were used in  the indicative loss rate table in SCAP: first-lien mortgages, prime  mortgages, Alt-A mortgages, subprime mortgages, second/junior lien  mortgages, closed-end junior liens, home equity lines of credit,  commercial and industrial loans, commercial real estate loans,  construction loans, multifamily loans, nonfarm nonresidential loans, credit  card balances, other consumer, and other loans. Once the data were  aggregated into these categories, we divided the net charge-offs by the  applicable average loan balance. This calculation showed the loss rate for  each category (e.g., first-lien mortgages and commercial real estate) for  the year ended December 31, 2009. This methodology was applied to  calculate the loss rates for the 19 SCAP BHCs and all BHCs with more than  $1 billion of assets, respectively. Because those institutions had recently  converted to being BHCs, Y-9C data on loan balances was not available for  the fourth quarter of 2008 for American Express Company; The Goldman  Sachs Group, Inc.; and Morgan Stanley, and was not available for GMAC  LLC for both the first quarter of 2009 and the fourth quarter of 2008.  Therefore, we approximated the loan balances in these periods for GMAC  LLC and American Express Company based on their Form 10-Q for these  time periods. Because The Goldman Sachs Group, Inc. and Morgan Stanley  have considerably smaller loan balances, in general, than the other BHCs;  the fourth quarter of 2008 balance was not approximated for these BHCs.  Instead, the average loan balance was simply based on the available data  (e.g., first quarter of 2009 through fourth quarter of 2009).
We conducted this performance audit from August 2009 to September 2010  in accordance with generally accepted government auditing standards.  Those standards require that we plan and perform the audit to obtain  sufficient, appropriate evidence to provide a reasonable basis for our  findings and conclusions based on our audit objectives. We believe that  the evidence obtained provides a reasonable basis for our findings and  conclusions based on our audit objectives.
section_title: Appendix II: Status of Bank Holding Companies’ TARP Investments as September 22, 2010
paragraphs: Twelve of the 19 bank holding companies (BHC) that participated in the  Supervisory Capital Assessment Program (SCAP) had redeemed their  Troubled Asset Relief Program (TARP) investments and had their  warrants disposed of as of September 22, 2010, and most of them were not  required to raise capital under SCAP (table 10). Six of the 19 BHCs tested  under SCAP have not repaid TARP investments or disposed of warrants,  and one, MetLife, Inc., did not receive any TARP investments. BHCs  participating in SCAP must follow specific criteria to repay TARP funds. In  approving applications from participating banks that want to repay TARP  funds, the Federal Reserve considers various factors. Some of these  factors include whether the banks can demonstrate an ability to access  the long-term debt market without relying on the Federal Deposit  Insurance Corporation’s (FDIC) Temporary Liquidity Guarantee Program  and whether they can successfully access the public equity markets,  remain in a position to facilitate lending, and maintain capital levels in  accord with supervisory expectations. BHCs intending to repay TARP  investments must have post repayment capital ratios that meet or exceed  SCAP requirements.
section_title: Appendix III: One-Year Actual Performance Compared to GAO’s Pro rata Stress Test Loss Projections for Each of the 19 SCAP BHCs
paragraphs: Table 11 shows the names, location, and total assets as of December 31,  2008, of the 19 bank holding companies (BHC) subject to the Supervisory  Capital Assessment Program (SCAP) stress test that was conducted by the  federal bank regulators in the spring of 2009. The stress test was a  forward-looking exercise intended to help federal banking regulators  gauge the extent of the additional capital buffer necessary to keep the  BHCs strongly capitalized and lending even if economic conditions are  worse than had been expected between December 2008 and December  2010.
The following tables (12 through 30) compare the 2009 performance of the  19 BHCs involved in SCAP to the 2-year SCAP estimates and the GAO 1- year pro rata estimates for the more adverse economic scenario.  Specifically, these tables include comparison of actual and estimates of  losses and gains associated with loans, securities, trading and  counterparty, resources, preprovision net revenue (PPNR), and allowance  for loan and lease losses (ALLL). These tables also include a comparison  of actual capital levels at December 31, 2009, and December 31, 2008.  Totals may not add due to rounding. For a more detailed explanation of  the calculations made in constructing this analysis, see appendix I.
section_title: Appendix IV: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix V: Comments from the Department of the Treasury’s Office of Financial Stability
section_title: Appendix VI: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: Daniel Garcia-Diaz (Assistant Director), Michael Aksman, Emily Chalmers,  Rachel DeMarcus, Laurier Fish, Joe Hunter, William King, Matthew  McDonald, Sarah M. McGrath, Timothy Mooney, Marc Molino, Linda Rego,  and Cynthia Taylor made important contributions to this report.