After years of testing, the Federal Reserve still looking to get liquidity stress assessments right.
Following the financial crisis the US Federal Reserve Bank initiated a series of measures to make sure financial institutions could withstand another crisis. Among these measures was Fed’s Comprehensive Capital Analysis and Review (CCAR). CCAR is the Fed’s annual exercise to assess whether the largest bank holding companies in the US, i.e., those with $50 billion or more in total consolidated assets, have “sufficient capital to continue operations throughout times of economic and financial stress and that they have robust, forward-looking capital-planning processes that account for their unique risks.”
In conducting these tests, the Fed looked to gauge banks’ capital adequacy, internal capital adequacy assessment processes, and their individual plans to make capital distributions, such as dividend payments or stock repurchases. In NeuGroup’s Bank Treasurers’ Peer Group (BTPG), these tests have been onerous and as such, have been a regular topic of many BTPG meetings since 2008. A breakout session at the group’s most recent get-together saw several CCAR-level banks discuss liquidity risk management under the Fed’s horizontal review, which is known as the Comprehensive Liquidity Assessment and Review (CLAR). On hand to help lead the discussion were the head of liquidity planning and bank holding company treasurer from a G-SIB (or global systemically important bank) bank and a consultant from Ernst & Young’s financial services office.
One key takeaway, according to the G-SIB treasurer, was that liquidity stress testing is still evolving, with the Fed trying to catch up to the rigors and complexities of CCAR banks. Recovery and resolution planning is in a similar state. Accordingly, the G-SIB treasurer’s bank used to run two separate groups to monitor each. Following specific guidance received this year, however, there is a need for more formalization of the governance process, so the frameworks have been combined.
Regulators are also focusing on self-sufficiency for the various entities of each institution. How to look at branches is a concern, for example. The other part of self-sufficiency is subjecting each legal entity to the same liquidity and stress requirements. Banks should think about modelling their preferred resolution path for these entities and define all material entities within this framework. The analysis might also give you a reason to sell/dispose of some entities. Documentation is also key and has been the focus of everything that the G-SIB treasurer’s team has done with the Fed for the past 18 months.
Every bank is supposed to have a second line of defense, but as one member noted, “it’s kind of like Tony Romo [prior to his new CBS commentating job]: they sit on the sidelines and don’t do much and get paid a lot of money.” Per an EY advisor at the meeting, the Fed’s expectation is that an independent review is a constant function and should provide an “effective challenge.”
“A lot of firms struggle with this concept,” the EY advisor said. His advice is to make a real effort to document discussions that have occurred and include the items showing that the second line made an effective challenge.
On the other hand, the first line of defense is easier, since it can be tasked to the ALCO or an ALCO subcommittee. Both approaches are reviewed. One member has the market risk team do a review for the second line or the enterprise risk management group. However, if ERM is a part of ALCO, this can raise questions about its being a second line. Best practice is to have the liquidity team second line be totally separate. Some members are thinking of having a separate model validation group do the review, and asked if that is overkill. The G-SIB treasurer said his team does this and EY said model valuation should happen as a matter of course.
Perhaps the topline takeaway from the session is that banks should pace themselves with peers and not overachieve. “Collaboration is your friend,” said one panelist. “If one of you overachieves, you all have to overachieve!” Therefore, “if anyone gets an A, we are coming after you,” said another treasurer.
Speaking with peers can also validate your current standing. One treasurer noted how he felt inadequate for Reg YY after receiving his letter (Reg YY implements enhanced prudential standards for certain companies supervised by the Board, including foreign banking organizations), but felt much better after he reached out to seven other regional banks to find that they all got the same letter. Their business models and practices were all the same, so it stood to reason. This is how it should be: Regulators will be doing cross-industry analysis and looking for outliers, EY warned. The other piece of advice to help mitigate future challenges is to push back against triangulation by the Fed, the OCC and state regulators. The main idea of a horizontal stress test is that the methods, models and standards are consistent across capital and liquidity as well as rate risk, but it also means that any bank’s methods should be consistent with its peers. Don’t be an overachiever, and benchmark with peers to ensure that you are within the standards.
You want to avoid constantly being in a “three-on-one-triangulation of hell.” One way to get out of it is to sell out-of-state chartered entities in states with aggressive regulators and/or get rid of your OCC charter. It should not have to be this way. As more member banks roll through the horizontal review cycles, they should share notes to make it a bit less painful for all.