PwC Journal Stress · The Journal Stress testing: From stressful times to business as usual ......
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Banking and Capital Markets The Journal Stress testing: From stressful times to business as usual August 2009
Transcript of PwC Journal Stress · The Journal Stress testing: From stressful times to business as usual ......
Banking and Capital Markets
The JournalStress testing: From stressful times to business as usual
August 2009
But the tests also raise a number ofother themes which have far widerrelevance for the industry and whichwill shape the way that banks thinkabout capital, run their businesses andmanage their risks for years to come.
For example, lower quality capital – tiertwo securities and even some tier onehybrids – now appears devalued atbest and irrelevant at worst. The focusis squarely on common equity as theprimary arbiter of an institution’sstrength. This is reasonable enoughgiven the events of the last two years,but the need to hold more – and moreexpensive – capital will have an impacton bank business models by makingcertain businesses more or lessattractive on the basis of their capitalconsumption. Advocates of economiccapital and similar approaches havelong argued that banks should userisk-based capital to inform strategicdecisions, but capital has been socheap and so plentiful that there wasno real imperative to do so. That couldnow change.
It might be tempting to see the stresstests as a one-off measure taken toresolve some of the uncertainty aroundUS banks. That would be a mistake.As the industry emerges from thecrisis, comprehensive stress tests lookset to become standard practice formanagement and supervisors, and akey way in which capital adequacy is
assessed. The results of ongoingtesting regimes will also help tostrengthen risk management oversightand will become an additional sourceof disclosure to the market.
This document summarizesPricewaterhouseCoopers’1
perspectives on the stress testingresults, including the implications of these changes over the short and medium term.
Higher capital charges for thebiggest US banks
As a result of the stress tests, bankcapital requirements have climbed.Prior to the tests, a minimum tier onerisk-based capital ratio of 6% was thesolvency requirement for a bank to beconsidered well-capitalised. Under thestress tests, that standard has beentoughened – the minimum 6% tier oneratio remains, but it must now be ableto withstand two years of worst caselosses. This represents an effectivecapital increase from current levels ofapproximately 100 basis points, onaverage, in addition to another 270basis points originally infused underthe US government Troubled AssetRecovery Program (TARP).
Fernando de la MoraPricewaterhouseCoopers (US)+646 471 [email protected]
Michael ShearerPricewaterhouseCoopers (US)+646 471 [email protected]
Dan WeissPricewaterhouseCoopers (US)+703 918 [email protected]
2 PricewaterhouseCoopers The JournalFrom stressful times to business as usual
Public debate of the Federal Reserve’s stress test results – whichcalled on 10 of the 19 largest US banks to raise $74.6 billion in additional capital – has tended to take the form of a lively back-and-forth about the appropriateness of the scenarios used, or has focused on the short-term implications for individualinstitutions. These issues are important.
1 “PricewaterhouseCoopers” refers to the network of member firms of PricewaterhouseCoopersInternational Limited, each of which is a separate and independent legal entity.
Although this is expected to be atemporary increase, it will still havebroader implications for the overallcost of doing business, impactingprofitability prospects across thebanking industry. Given that banks add strategic capital buffers to financefuture growth and acquisitions – and to secure possible TARP capitalrepayment – banks will likely keepgreater levels of capital in addition tothe minimum thresholds proposed bythe government.
Open questions also remain abouthow the tests – and the capital levels they have set – will be integrated into the future regulatorycapital framework:
• When will these additional capitaltargets be refined or lifted?
• Will the apparent pro-cyclical natureof the targeted capital buffers beeliminated if regulatory capital isrevised – as expected – to make itmore counter-cyclical?
• Will there be higher targets for larger,more complex banks, or those withconcentrated exposures?
• How will the new stress testguidelines be factored into existingrules on capital?
• Are the new stress test requirementsapplicable to other banks that were not included among theoriginal 19 institutions?
Capital quality standards have changed
The stress tests have introducedstricter expectations about thecomposition and quality of capital.Prior to the stress tests, there weresome qualifications and limitationsbuilt into the definition of regulatorycapital, but no explicit requirementsrelating to tier one common equity –European regulators had been workingto produce harmonised rules on capitalquality prior to the start of the crisis,but the project focused primarily onhybrid capital.
The stress tests establish de factostandards for capital composition, by setting a minimum 4% ratio forcommon equity to risk-weightedassets after factoring in losses in anadverse stress scenario. In fact, mostbanks achieved a tier one ratio of morethan 6% after applying the tests,which indicates that the vast majorityof the required capital will be raised to meet the new minimum tier onecommon equity threshold. As a result, the relative attractiveness of preferred share instruments and other hybrid structures may bereduced in the future (see figure 1).
PricewaterhouseCoopers The Journal 3From stressful times to business as usual
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Capital-raising plans are needed
As a result of the new capital qualityexpectations, banks that need morecapital will focus on generatingadditional common equity through newissuance, sales of businesses orassets, and the potential conversion ofpreferred shares. Those banks withouta capital shortfall under the terms ofthe tests will focus on developingplans to repay TARP capital as soon asthey are allowed. All banks that are notbeing asked to raise capital will meetthe minimum 6% tier one ratio underan adverse scenario even afterrepaying all TARP capital.
Impact on bank businessmodels
Under the new restrictions, return oncapital will take a hit – in the mediumterm, this is where managementattention is likely to be focused. Itremains unclear whether banks will beable to earn enough profits across alltheir asset classes and activities tosupport post-crisis expectations forcapital and liquidity. This isn’tnecessarily a disaster – but banks willhave to revisit and refine their businessmix based on how each one stacks upin terms of its impact on futureperformance and returns on capital.
As evidenced by the size of futurepotential losses in some loan classes (see figure 2), banks will be forced to consider: (1) carving out or spinning off assets,portfolios or businesses that consumemore capital in stress scenarios; (2) re-pricing lending risk andintroducing more differentiated pricingfor customers, products andbusinesses that are capital-intensive;and (3) other restructuring options tooptimise their use of capital.
These considerations don’t just impactlending businesses, but also sales andtrading activities. If the regulators andother stakeholders promptmanagement to consider measuressuch as a stress Value-at-Risk (VaR)approach for capitalizing sales andtrading businesses, capitalrequirements could be significantlyhigher. Projected stress test losses forfive selected banks with trading assetsgreater than $100 billion represented,on average, nine times their two-weekVaR, including a regulatory capitalmultiplier of three. As capital guidelinesfor sales and trading migrate fromtraditional VaR to stress VaR, bankswill need to evaluate the impact interms of returns and capitalconsumption.
Figure 1
Source: SCAP and PricewaterhouseCoopers analysis
15%
Thresholds
6% Tier 1
10%
5%
0%
-5%
Am
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BB
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BN
YM
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Gol
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Key
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Sun
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Bank Holding Companies with no capital shortfall
Tier 1 Common Tier 1 Tier 1 if TARP repayed
Bank Holding Companies with capital shortfall
4% Tier 1Common
Stress testing is the new norm
The crisis will pass, but stress tests arehere to stay. Banks’ own in-housetests will become a more integral partof business-as-usual activities, helpingto inform business planning andforecasting, capital allocation,execution and performance evaluationprocesses. There’s work to be done asbanks make the transition to this newregime – some institutions havestruggled to capture the data andperform the analytics required torespond to their regulators in anorganised and effective way. Theprocess is complex and involves allbusiness units, treasury, finance and risk functions, and ultimately the chief executive.
Developing sustainable stress testingcapabilities and processes is essential– we expect that stress tests and theirsubsequent capital and liquidityplanning practices, including thevetting of new businesses, will gainprevalence relative to other internal riskmanagement techniques. Newscenarios will need to be generatedand calibrated over time to capturechanging macroeconomic conditionsand emerging risks.
In addition, loss mitigation activitieswill continue to take centre stage –banks that acted quickly to mitigatelosses have been able to createsubstantial benefits from their stresstest results, but this process is still inits early stages in many consumer andcommercial credit portfolios.
From a regulatory standpoint, thebanking supervisors have elevated andformalized a more comprehensive,rigorous, forward-looking andcollaborative process relative to theirprior supervision of capital adequacyand management practices. Someaspects of the stress test exercise arelikely to be incorporated intosupervisory processes from now on.
Reinforced risk managementand new disclosures
Risk management effectiveness needsto be certified by the executivemanagement team and ultimately theboard. Supervisors expect that, as partof the capital planning process, firmswill need to review both their existingmanagement and the board to ensurethe leadership of the firm has sufficientexpertise and ability to manage therisks it faces.
To meet this expectation – and to keepimproving the effectiveness of riskmanagement – executive managementteams will need periodically to assesstheir institution’s risk governance andoversight structures, culture andincentives, risk management andmeasurement processes, as well asresources and the supporting risk ITinfrastructure. To be effective, thisassessment should be conducted on a regular basis and independently of line management; it should befocused on identifying opportunities forimprovement; and its results should beshared with the board of directors.
We expect banks to be transparentabout stress test results and explainon an ongoing basis (i) their stress/scenario methodologies and anydifferences between their assumptionsand those being used by theregulators, as well as (ii) the resulting capital management actions to investors.
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Figure 2
Source: SCAP andPricewaterhouseCoopers analysis 1st quartile 2nd quartile 3rd quartile 4th quartile
First lien mortgages
Second/junior lien mortgages
Commercial & industrial loans
Commercial real estate loans
Credit card loans
0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%
Maximumindicative lossrate provided by regulatoryagencies atbeginning ofstress testexercise
20%
12%
8%
16%
8.5%
ContactsFernando de la MoraPricewaterhouseCoopers (US)+646 471 [email protected]
Michael ShearerPricewaterhouseCoopers (US)+646 471 [email protected]
Dan WeissPricewaterhouseCoopers (US)+703 918 [email protected]
ContactsShyam VenkatPricewaterhouseCoopers (US)+646 471 [email protected]
Fernando de la MoraPricewaterhouseCoopers (US)+646 471 [email protected]
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