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To Keep Strong Even in Bad Times, More Banks Test Themselves

For the first time, regional banking organizations with assets between $10 billion and $50 billion are required to conduct stress tests and disclose results. The overarching goal? To ensure that even in times of crisis, banks have the capital they need not only to survive, but to keep lending.

In the words of one senior vice president of finance, this was a meeting regional bankers couldn’t afford to miss.

About 200 bankers attended a day-long Dodd–Frank Stress Testing Symposium where regulators and bankers discussed company-run stress tests, a new requirement regional banks face.

Officials were in attendance from most of the approximately 70 US regional banking organizations that in 2015 must run these tests to assess their capital adequacy.

The focus on bank capital certainly intensified following the Great Recession. It’s only recently that stress testing became required of regional banking organizations, defined as banks having assets between $10 billion and $50 billion.

The Dodd–Frank Wall Street Reform and Consumer Protection Act requires the testing. Regulatory agencies, such as the Federal Reserve, issue guidance on how the testing requirements will be implemented.

On the larger scale, banks with assets of more than $50 billion have been required to conduct different, more comprehensive stress testing for several years.

What bankers and their regulators run the tests to glean is, how would a bank’s capital withstand adverse economic scenarios?

For example, what might be the fallout for an institution if the local manufacturing plant shuts down? Or, if an institution’s portfolio is heavily concentrated in one form of lending, what might happen in the event of an economic downturn?

“That’s what stress testing is,” Jeffery Stanovich, a senior examination specialist with the Federal Deposit Insurance Corporation (FDIC), said while speaking on a panel at the symposium. “Today, we’re putting numbers to it. How much capital do I need?”

Capital is a cushion—dollars that help an institution absorb unexpected losses. And there’s more at stake than the institution itself. The availability of bank capital in good times and bad carries importance for the regional economies in which institutions operate, banking insiders say. For one, a bank that finds itself in an undercapitalized position—like many did during the financial crisis—may reduce or outright stop lending.

A bank that finds itself in an undercapitalized position—like many did during the financial crisis—may reduce or outright stop lending.

And there begins what can be an unfortunate cycle for any region, even when the lender isn’t a systemically important institution with national reach, said Stephen H. Jenkins, the Cleveland Fed’s senior vice president who oversees the Bank’s supervision and regulation of financial institutions. A bank’s inability to lend affects economic growth in the regions it serves, and when a regional economy struggles, a bank’s customers may be rendered less able to stay current on loans they’ve borrowed. So, regulators want banks to be capitalized to the extent that even in severe economic downturns, they’re able to continue to lend to creditworthy customers.

“Access to capital, to loans, is the oil that lubricates the economy,” explains Jenkins. “It becomes a downward spiral. Creditworthy customers can’t get credit. If it’s business owners who can’t, then they can’t help the economy expand through expanding their business and hiring new employees.

“These regional banks are critically important to the regions that they serve,” Jenkins adds. “A regional bank is not a JPMorgan Chase, but that doesn’t mean in Akron, Ohio, a FirstMerit Corporation isn’t as important.”

For its part, the Federal Reserve Bank of Cleveland — which supervises four regional banking organizations, among them Akron, Ohio-based FirstMerit Corporation and Pittsburgh-based FNB Corporation—is conducting research to better understand the relationship between the health of regional banks and the health of regional economies.

A domino effect

Bank capital levels have generally risen in the years since the financial crisis.

Such capital comes from varied sources, including retained earnings. Banks also can raise capital through the sale of stock, for which investors pay to own a piece of the company. However, in times of financial crisis, raising capital can be hard-fought—even impossible.

Put another way, it is before adverse scenarios that capital should be shored up, notes Nadine M. Wallman, vice president in the Cleveland Fed’s Supervision and Regulation Department.

“Not surprisingly, when we find the economy is going through difficult times, we often find that bank capital is being depleted,” notes Dr. Kevin T. Jacques, who worked to develop and write capital regulations for the US Department of the Treasury, where he worked for 14 years.

The relationship between the economy and bank capital can run the other direction, too, adds Dr. Jacques, today the Boynton D. Murch chair in finance at Baldwin Wallace University in Berea, Ohio.

“A bank can become sick or unhealthy because it’s just not doing its business well,” or because its portfolio lacks diversification, he explains. “It can have nothing to do with the macroeconomy. If you get a large enough group of banks to which that happens, it can cause the economy in that region to stagnate.”

The Cleveland Fed calls it contagion—when one firm’s insolvency affects other firms connected to it.

Dr. Jacques cites as an example the domino effect the substantial decline in oil prices had in the 1980s in Texas. Numerous oil firms had borrowed money from the financial system, and as those companies failed, bank capital levels decreased to such an extent that some Texas banks failed right along with them.

Such destabilization of banking is what regulators seek to avoid in sharpening the industry’s focus on capital, Jacques explains. While the depositors of a bank rendered insolvent are protected by deposit insurance through the FDIC up to a certain amount, regulators have their eye on more than deposits. There’s the safety and soundness of the whole financial system to sustain, and large-scale financial crises to avoid.

Besides, he notes, even where deposits are fully protected, bank customers still lose something if their bank disappears from the banking landscape.

“What ends up happening is when a bank fails, a lot of those relationships between a bank and the mom-and-pop store, the bank and the business owners, the bank and the person who wants to borrow money to go to college, a lot of those relationships get broken,” he says.

Notes for round two

Regional banks completed their first annual, company-run, Dodd–Frank Act-mandated stress test in early 2014. Last year’s symposium—hosted in Cleveland by the Federal Reserve, the Office of the Comptroller of the Currency, and the FDIC—provided a forum for regulators to discuss key themes arising from the first round of stress tests. Additionally, the symposium provided an opportunity for bankers to discuss stress testing practices with their peers and to seek clarity on supervisory expectations. Dodd–Frank financial reform allotted institutions a year to run the tests without disclosing the results; 2015 will be the first year during which regional banking organizations must publicly disclose them.

They must share only the results of the severely adverse or extreme-case scenarios they run, the Fed’s Wallman explains. The disclosures are a means of fostering greater transparency to the industry.

Regulators won’t use the regional bank stress test results to approve or object to actions midsize banks want to take regarding their capital, such as paying dividends. Regulators do use stress test results in this way for larger organizations submitting to the Comprehensive Capital Analysis and Review, or CCAR. CCAR—required of bank holding companies with assets of $50 billion or more—requires not only more sophisticated stress testing approaches but also entails a supervisory test conducted by the Federal Reserve.

Many regional banks are new to scenario-based stress testing, so many of them are on a learning curve.

Some common themes highlighted during the symposium include ensuring institutions have the necessary qualitative information supporting their risk management framework and process for stress testing, such as documenting assumptions and the limitations they encounter.

Directors, several regulators emphasized, are ultimately responsible for aligning their post-stress test results with their firm’s capital goals and risk appetite.

Board of director involvement is also important. Boards need to stay informed about the stress testing, and what it reveals. Directors, several regulators emphasized, are ultimately responsible for aligning their post-stress test results with their firm’s capital goals and risk appetite. “We do not expect the board of directors to be statisticians,” explained Alisha Riemenschneider, a senior analyst with the FDIC. “What we expect is they understand the main framework…the bank’s vulnerabilities, and how that’s being captured so they can have a meaningful dialogue with bank executives on the stress testing process and results.” In addition, data is an important element for stress testing. Having quality data sets and staff with the skill sets needed to conduct the stress tests and analyze the results are important. Hiring a third-party vendor appears to be a fairly common practice for regional banks, but does add vendor management risk responsibilities.

“While firms may have conducted some forms of stress testing in the past, they aren’t used to doing scenario-based stress testing,” Wallman explains. “This requires different data sets and, in particular, more granular and quality historical data sets.”

So, two clear messages: Bankers, ensure you have effective risk management and corporate governance processes, and strengthen your data collection.

And, another? Those contemplating and executing mergers and acquisitions should be planning accordingly if they expect to grow to the size (north of $50 billion) where they’ll need to perform the more complex Comprehensive Capital Analysis and Review. Ramping up for it will not be accomplished overnight.

‘Quite a ways to go’

Stress tests are not meant to be throw-away exercises, regulators stressed during the symposium. They’re intended to be tools bankers use to improve their businesses and their management of risk. Where red flags are raised, the hope is that bankers will make decisions to change their risk profiles, perhaps by deleveraging; incorporating additional thresholds, or concentration levels, for certain kinds of lending; etc., Wallman says.

Drawing up clearly articulated capital goals and a method of notifying a bank’s board if a bank’s capital is approaching such levels were among the capital planning practices discussed during the symposium.

“Firms should not treat this as a regulatory exercise,” Jenkins says. “If they just throw it in a desk drawer, they’re missing a huge opportunity and not complying with the intent of these stress tests.

“We do recognize there is a cost to these organizations,” Jenkins says. “However, I believe that the benefits to these organizations and to the financial system as a whole more than justifies putting these processes into place. If they really use the information to make business decisions, I actually think they’re getting a significant return on their investment.”

One banker said he expects that the stress tests, over time, will be positive.

“We think it can really help us manage our business better,” he said while at the symposium. “The perception is that we are a conservative bank. This reinforces that.”

But there’s work to do. His team members are working to get their arms around validating their models and collecting data differently.

“My major takeaway is we do have quite a ways to go,” he said. He clearly wasn’t the only banker in the room thinking it. Speaking up during the symposium, another banker noted: “Many days the stress-testing process is managing me, rather than me managing it.”

The intent, of course, is that as regulators answer questions and provide guidance and feedback, bankers increasingly command the process and produce insights that result in stronger banks, even when times are tough.

To stress test, or not to stress test

Though it is less complex than the testing required of the largest US banks, stress testing is now required of regional banking organizations. Community banks face no such mandate. Here’s a look at how they all differ.

Large Banks

Assets of more than $50 billion
Examples you might know: Cleveland-based KeyBank and Pittsburgh-based PNC Bank.
Stress test required? Yes, since 2009. The Federal Reserve conducts the Comprehensive Capital Analysis and Review, or CCAR, annually. Based on the stress testing results, the Fed chooses to object or not object to capital plans submitted by the banks.
In plain speak: Generally, these banks are more complicated and more plugged into the national and global financial system. They have a national and international scope of service.

Regional Banks

Assets of $10 billion to $50 billion
Examples you might know: Akron-based FirstMerit Bank and Pittsburgh-based First National Bank
Stress test required? Yes, and a first round was completed in 2014. Financial reform requires the stress testing, and regulators, including the Federal Reserve, set forth guidelines for how the tests are to be implemented. There is no supervisory test; companies conduct their own stress tests.
In plain speak: Though large, regional institutions tend not to be so complex that if they fail, it would have national financial market implications. They service broad US regions.

Community Banks

Assets of less than $10 billion
Examples you might know: Lorain, Ohio-based Buckeye Community Bank and Cincinnati-based First Financial Bank 
Stress test required? No. 
In plain speak: Banks of this size can be closed relatively simply and with limited impact on their regional economies. They service local markets.

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