Stress-Testing Insights: Financial Forecasts in a Post-DFAST World
The Economic Growth, Regulatory Relief, and Consumer Protection Act, signed into law May 24, 2018, generally is regarded as the most significant reworking of banking industry regulations since the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).
In fact, the new act was written specifically to provide significant relief from a number of Dodd-Frank requirements, with one of its most widely anticipated provisions being the rollback of Dodd-Frank Act stress-testing (DFAST) requirements for all but the very largest financial organizations.
As significant as this development is, however, banks and other financial services organizations are advised not to consider the new act as an opportunity to abandon stress-testing activities altogether. Instead, they should communicate with their regulatory agencies to determine what their financial forecasting and capital planning expectations will be in a post-DFAST environment.
Moreover, now that they no longer need to focus on adherence to rigid, standardized DFAST formats and reporting requirements, financial services organizations have an opportunity to redirect their resources toward producing more useful and effective financial forecasting. Ideally, post-DFAST stress testing will provide senior management and board members with more tailored and directly applicable insight into the potential impact of future economic events.
Nevertheless, the banking industry in general has been quick to welcome the act’s passage. For example, when participants in one recent Crowe webinar were asked for their reactions to the new law, the leading response was one of general relief at an expected reduction in the amount of regulatory oversight (Exhibit 1).
In fact, the new act was written specifically to provide significant relief from a number of Dodd-Frank requirements, with one of its most widely anticipated provisions being the rollback of Dodd-Frank Act stress-testing (DFAST) requirements for all but the very largest financial organizations.
As significant as this development is, however, banks and other financial services organizations are advised not to consider the new act as an opportunity to abandon stress-testing activities altogether. Instead, they should communicate with their regulatory agencies to determine what their financial forecasting and capital planning expectations will be in a post-DFAST environment.
Moreover, now that they no longer need to focus on adherence to rigid, standardized DFAST formats and reporting requirements, financial services organizations have an opportunity to redirect their resources toward producing more useful and effective financial forecasting. Ideally, post-DFAST stress testing will provide senior management and board members with more tailored and directly applicable insight into the potential impact of future economic events.
Highlights of the Economic Growth, Regulatory Relief, and Consumer Protection Act
The Economic Growth, Regulatory Relief, and Consumer Protection Act is composed of six major sections. Three of those sections are particularly far-reaching in providing regulatory relief to financial institutions:- Title I: Improving consumer access to mortgage credit. In addition to rolling back a number of Dodd-Frank provisions, the new law makes important changes to several far-reaching statutes that govern the consumer mortgage industry, including the Truth in Lending Act of 1968 (TILA), the Home Mortgage Disclosure Act of 1975 (HMDA), and the Financial Institutions Reform, Recovery, and Enforcement Act of 1989.
For example, banks with less than $10 billion in assets now may be allowed to forgo some of the TILA-mandated qualified mortgage and ability-to-pay requirements for certain customers. The law also allows exemptions from some of the TILA escrow requirements for mortgages that are held by banks that have less than $10 billion in assets, originate 1,000 or fewer mortgage loans per year, and meet certain other requirements. Some HMDA public disclosure requirements also may be waived for some banks that originate fewer than 500 mortgages per year, a significant easing from the previous cap of 25 mortgages per year. - Title II: Regulatory relief and protecting consumer access to credit. The new law eases many Federal Deposit Insurance Corporation (FDIC) and Federal Reserve Board (FRB) reporting requirements for community banks. For example, banks with less than $10 billion in assets will be deemed to be in compliance with U.S. Basel III-based capital requirements as long as they maintain a “community bank leverage ratio” of at least 8 to 10 percent. Banks with less than $10 billion in assets also will be exempted from the Volcker Rule prohibition on proprietary trading transactions as long as their traded assets and liabilities amount to less than 5 percent of the bank’s total consolidated assets.
Banks with $5 billion in assets or less will be able to satisfy FDIC reporting requirements using a short-form Consolidated Report of Condition and Income (call report). In addition, for banks with $3 billion in assets or less, the exam cycle has been extended to 18 months from 12 months. - Title IV: Tailoring regulations for certain bank holding companies. The new law significantly increases certain critical thresholds that determine when enhanced prudential standards will be required of banks and bank holding companies (BHCs). For example, the definition of a systemically important financial institution (SIFI) has been changed to include only BHCs with $250 billion or more in assets – a significant increase from the previous level of $50 billion. There is an 18-month phase-in period for organizations with more than $100 billion in assets. After 18 months, only BHCs with $250 billion in assets or more will be required to meet the enhanced standards, which include the requirement for company-run stress tests.
The FRB also is given greater discretion in applying stress-testing requirements in general. For example, rather than requiring BHCs with $250 billion or more in assets to perform semiannual stress tests, the new law requires only that these largest institutions perform “periodic” stress tests. Furthermore, the “adverse” scenario has been eliminated, so those organizations that are still subject to stress-testing requirements will need to test only the “baseline” and “severely adverse” scenarios.
Expected impact and industry reaction
Regulatory agencies are now in the process of reworking their examination and supervisory processes to incorporate the changes mandated by the new law. This effort is expected to continue for some months, so the full impact of the regulatory relief efforts will become clearer over time.Nevertheless, the banking industry in general has been quick to welcome the act’s passage. For example, when participants in one recent Crowe webinar were asked for their reactions to the new law, the leading response was one of general relief at an expected reduction in the amount of regulatory oversight (Exhibit 1).
Source: Online survey of Crowe webinar participants, June 19, 2018. Note: Numbers might not equal 100% due to rounding.
About one-fourth (24 percent) of the webinar participants indicated they viewed the new law’s most appealing aspect to be the expectation that regulatory relief would help them reduce the costs associated with credit provision and compliance. But an even larger portion of the respondents (34 percent) cited the opportunity to build on some of the stress-testing disciplines that DFAST had instilled in their organizations, or to adapt their stress-testing practices to be more applicable to their own situations.
Stress testing in a post-DFAST world
As the survey responses indicate, most banks appear to recognize that passage of the Economic Growth, Regulatory Relief, and Consumer Protection Act did not necessarily mean the end of stress testing altogether. In fact, in response to another question, a clear majority of the webinar participants indicated their bank's plan to continue various aspects of their existing stress-testing regimens in some form, while only a tiny percentage expected to eliminate stress testing outright (Exhibit 2).
Source: Online survey of Crowe webinar participants, June 19, 2018. Note: Numbers might not equal 100% due to rounding.
The question banks now must address is how they should modify their stress-testing policies and processes to adapt to the post-DFAST environment. The objective would be to continue achieving the benefits stress testing can provide, while at the same time taking advantage of opportunities to achieve cost savings due to the elimination of certain DFAST compliance and reporting requirements.
Among the likely savings are reductions in governance costs associated with DFAST oversight, model risk management, and the associated effective challenge, documentation, submission, and examination activities. Industry experience suggests these can represent anywhere from 30 to 60 percent of the effort involved in maintaining a DFAST framework.
In addition to internal cost savings, many banks might be able to reduce outsourcing costs. Alternatively, some banks might find it more advantageous to consider outsourcing additional components – or even the entire forecast and modeling effort – in order to achieve greater cost savings in terms of internal resources.
As attractive as the savings opportunities are, it is important to remember that stress testing as a practice is not solely a DFAST creation. Various other regulations require banks to have stress-testing capabilities as part of their capital management and governance structure.
Looking beyond compliance alone, stress testing is a proven tool for providing management with useful insights and value. In the post-DFAST environment, many banks should plan to refocus and reprioritize their forecasting approaches to align more closely with their business priorities, particularly in the area of credit risk management. Many of the DFAST models – and the data they collected – can be adapted to support allowance for loan and lease losses (ALLL) calculations, particularly as banks adapt to the new current expected credit loss (CECL) standard.
The disciplined application of stress testing can provide critically needed support and insight in all stages and to all participants in the capital planning process, from initial risk identification to the actual assessment of how much capital a designated risk might require. Carrying the effort forward, stress testing and other types of sensitivity analyses also can be helpful in determining how capital assessments could be altered by changes to the business plan or strategy. Guidance on how to proceed can be found in the Office of the Comptroller of the Currency’s recently updated handbook.1
The regulatory relief provided by the Economic Growth, Regulatory Relief, and Consumer Protection Act is both welcome and significant. Yet, ultimately, most leading banking organizations are looking upon this situation as an opportunity to improve and customize their stress-testing regimens, rather than eliminating this valuable practice altogether.
Among the likely savings are reductions in governance costs associated with DFAST oversight, model risk management, and the associated effective challenge, documentation, submission, and examination activities. Industry experience suggests these can represent anywhere from 30 to 60 percent of the effort involved in maintaining a DFAST framework.
In addition to internal cost savings, many banks might be able to reduce outsourcing costs. Alternatively, some banks might find it more advantageous to consider outsourcing additional components – or even the entire forecast and modeling effort – in order to achieve greater cost savings in terms of internal resources.
As attractive as the savings opportunities are, it is important to remember that stress testing as a practice is not solely a DFAST creation. Various other regulations require banks to have stress-testing capabilities as part of their capital management and governance structure.
Looking beyond compliance alone, stress testing is a proven tool for providing management with useful insights and value. In the post-DFAST environment, many banks should plan to refocus and reprioritize their forecasting approaches to align more closely with their business priorities, particularly in the area of credit risk management. Many of the DFAST models – and the data they collected – can be adapted to support allowance for loan and lease losses (ALLL) calculations, particularly as banks adapt to the new current expected credit loss (CECL) standard.
Stress testing’s role in capital planning
Looking beyond its immediate risk management applications, stress testing should be regarded as an integral part of the broader capital planning production framework. In this area, the practice of stress testing can make a particularly direct and significant contribution.The disciplined application of stress testing can provide critically needed support and insight in all stages and to all participants in the capital planning process, from initial risk identification to the actual assessment of how much capital a designated risk might require. Carrying the effort forward, stress testing and other types of sensitivity analyses also can be helpful in determining how capital assessments could be altered by changes to the business plan or strategy. Guidance on how to proceed can be found in the Office of the Comptroller of the Currency’s recently updated handbook.1
The regulatory relief provided by the Economic Growth, Regulatory Relief, and Consumer Protection Act is both welcome and significant. Yet, ultimately, most leading banking organizations are looking upon this situation as an opportunity to improve and customize their stress-testing regimens, rather than eliminating this valuable practice altogether.
1 Office of Comptroller of the Currency, “Comptroller's Handbook, Capital and Dividends” Version 1.0, July 2018.
people
