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. 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. 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.