Inside the 'Black Box' of the Fed's Stress Test

First of two parts

WASHINGTON — The Federal Reserve Board's annual stress tests are sometimes seen as a secret process, unfathomable from the outside, where banks submit reams of information to the central bank and receive a result a few months later.

But the tests are in fact a highly organized process involving hundreds of Fed employees from across the central banking system. What follows is one of the most extensive peeks into the process, based on research and interviews with individuals involved:

1. Collecting the data
It starts each year after the Fed develops and publishes three economic scenarios demonstrating various degrees of economic stress — the baseline, adverse and severely adverse. The scenarios, usually published in October, are meant to consider not only an isolated event but the ancillary effects of such an event. For example, in this year's severely adverse scenario, the tests consider a major weakening of global economic activity and an erosion of asset prices, as well as an unrelated (and, in hindsight, unlikely) spike in oil prices. That scenario foresees a jump in unemployment up to 10% and a drop in GDP of 4.5% and lower Treasury yields.

Banks with more than $50 billion in assets are required to submit vast quantities of data on their capital plans for the stress tests. Their submissions account for roughly $14 trillion in assets, or around 80% of the U.S. banking system.

[Conference Program Note: Join senior executives and other experts at Stress Testing 2015 , an American Banker event focused on navigating the stress testing process — and putting the results to maximum analytical benefit for your bank.]

The submissions can easily run 500 or more pages per bank, and are sent to the Fed via a specially-built communication portal between the banks and the Federal Reserve Bank of New York, which manages the portal (though it was designed and operated by the Fed Board in Washington, D.C.). The portal is used exclusively for stress test-related data transfers and was set up in order to ensure the highly sensitive material is kept completely secure.

The Fed receives upward of 10,000 files from the 31 firms examined in the stress tests, including background and supporting documentation. For this year's stress tests, the data was submitted on Jan. 5, and is generally due the first Monday after New Year's Day.

2. Organizing and analyzing the data
Once the Fed acquires the data, it is tagged with "metadata" tags — a new innovation for the 2015 stress tests — in order to make the vast quantities of information more easily sortable and understandable. The data is checked by 31 on-site examiner teams for each of the systemically important financial institutions to ensure that the data is consistent with itself and also with the information routinely submitted to the bank regulators.

Once the data is cleared, it is parceled out among 12 specialized teams, which examine various aspects of each bank's submission individually. Even smaller teams within those 12 will examine specific aspects of the stress test for each bank. All told, roughly 600 staff members of the Fed will deal with stress test results at some point in the process.

The 12 teams are composed of personnel from throughout the Federal Reserve System and are split up to focus in five general areas: scenario design and evaluation; risk evaluation; capital and revenue assessment; capital adequacy process review; and supervisory onsite teams.

Most of the teams operate under either the risk evaluation or the capital and revenue assessment teams. Under risk evaluation, there are separate subteams for retail credit risk, wholesale credit risk, operational risk, securities risk, counterparty risk and trading risk. Under the capital and revenue banner there are three subteams: a pre-provision net revenue and balance sheet team, a regulatory capital transition team, and a risk-weighted asset projections analysis team.

3. Breaking down the tests
The stress test process is really three separate tests, which have certain things in common but are aimed at measuring different things. Each of the tests measures the banks' performance over the next nine quarters. Each analyzes a bank's capitalization at the end of that nine-quarter horizon and whether the capital level goes below the statutory minimum at any point during those nine quarters under each of the stress scenarios.

The first test, called the Dodd-Frank Act Stress Test (or DFAST), is aimed at comparing banks' balance sheets to one another. It does this by running the bank data through each of the three scenarios using a standardized capital management plan, which is an average dividend disbursement over the firm's previous four quarters and zero stock buybacks. The result's of this year's DFAST test are due out Thursday, March 5.

The next two tests are part of the Comprehensive Capital Analysis and Review. The quantitative part of the CCAR runs each bank's financial information using the banks' own capitalization plan, measuring how each of the banks would navigate the Fed's three scenarios using their own playbook.

But CCAR also includes a qualitative test, where the banks themselves have to run stress tests based not on the Fed's scenarios but on the banks' own idiosyncratic risks and vulnerabilities. The Fed effectively grades the banks on whether its internal stress tests are vigorous enough to unearth weaknesses in the banks' balance sheet. Last year, only one bank, Zions Bancorp., failed the quantitative part of the CCAR, while four others, including Citigroup, failed the qualitative part. The results of this year's tests for both parts of CCAR will be announced on Wednesday, March 11.

When the 12 teams have completed their analysis of each bank's performance in each aspect of the stress scenarios, the results are knitted back together as a coherent result by the CCAR Executive Committee, known as the "Ex-Co." The Ex-Co is composed of 12 staff members from throughout the Fed system, including regional banks and the Fed Board. Each member of the committee is responsible for evaluating the submissions of one of the individual teams. The teams submit "draft results" to their Ex-Co members, who will then vet the results and make recommendations.

CCAR's qualitative examination is a unique process whereby the Fed examines the adequacy of a bank's preparation to mitigate certain risks. For example, a team might find that a bank's process for identifying and correcting operational risk is inadequate, even though it may have passed the quantitative side of the CCAR test.

4. Grading the tests
Contrary to what some banks and outsiders claim, the banks' capital plans are not "graded on a curve," or compared directly to one another. Indeed, the structure of the review teams is such that a team examining one bank's capital plan would not see what another bank was doing to address the same risk. But the Ex-Co does keep track of which banks have performed especially well and might suggest ways for banks performing less well to improve. It is also true that the largest banks subject to CCAR are held to a higher standard than the smaller regional banks subject to the stress tests, as is required by the Dodd-Frank Act.

The qualitative CCAR standards also do not ramp up from year to year — a common charge leveled at the Fed by bankers. Banks that are new to the CCAR process are generally given some time to get their systems up to speed, and most banks do not receive objections. But all banks are expected to be competent at identifying and assessing the risk areas covered in CCAR, and the Fed works with institutions to improve their internal modeling if they have only recently been subject to the CCAR rules.

In addition to rejecting capital management plans during the regular annual stress tests, CCAR also allows the Fed to require banks to submit a new capital management plan at any time during the year if there is a major change. That authority, called the "material change clause" of the CCAR rule, has never needed to be used, but ensures that banks adhere to the capital management plans they submit during the stress test.

If a bank fails any of the stress tests, there are significant consequences. Banks are prevented from buying back stock or distributing dividends unless they submit new, revised capital plans that meet the quantitative requirements — in the case of DFAST and the quantitative side of CCAR — or meet the qualitative standards laid out by the Fed in their rejection notice. 

While the process changes somewhat from year to year, this year's most significant change is that the more foreign banks will be subject to the stress test regime. While observers are watching to see whether banks like Citigroup fail again (something that could have severe consequences for the bank in the market), it's also possible some of the new foreign-based banks could have trouble, given the discrepancies between U.S. stress testing standards and those in place elsewhere.

This article is the first of two examining the Fed's stress tests in detail prior to their release this year. The second will focus on how the stress tests have evolved during the past five years, as well as criticisms leveled at the process.