Troubled Asset Relief Program:

Bank Stress Test Offers Lessons as Regulators Take Further Actions to Strengthen Supervisory Oversight

GAO-10-861: Published: Sep 29, 2010. Publicly Released: Sep 29, 2010.

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The Supervisory Capital Assessment Program (SCAP) was established under the Capital Assistance Program (CAP)--a component of the Troubled Asset Relief Program (TARP)--to assess whether the 19 largest U.S. bank holding companies (BHC) had enough capital to withstand a severe economic downturn. Led by the Board of Governors of the Federal Reserve System (Federal Reserve), federal bank regulators conducted a stress test to determine if these banks needed to raise additional capital, either privately or through CAP. This report (1) describes the SCAP process and participants' views of the process, (2) assesses SCAP's goals and results and BHCs' performance, and (3) identifies how regulators and the BHCs are applying lessons learned from SCAP. To do this work, GAO reviewed SCAP documents, analyzed financial data, and interviewed regulatory, industry, and BHC officials.

The SCAP process appeared to have been mostly successful in promoting coordination, transparency, and capital adequacy. The process utilized an organizational structure that facilitated coordination and communication among regulatory staff from multiple disciplines and organizations and with the BHCs. Because SCAP was designed to help restore confidence in the banking industry, regulators took unusual steps to increase transparency by releasing details of their methodology and sensitive BHC-specific results. However, several participants criticized aspects of the SCAP process. For example, some supervisory and bank industry officials stated that the Federal Reserve was not transparent about the linkages between some of the test's assumptions and results. But most of the participants in SCAP agreed that despite these views, coordination and communication were effective and could serve as a model for future supervisory efforts. According to regulators, the process resulted in a methodology that yielded credible results. By design, the process helped to ensure that BHCs would be capitalized for a potentially more severe downturn in economic conditions from 2009 through 2010. SCAP largely met its goals of increasing the level and quality of capital held by the 19 largest U.S. BHCs and, more broadly, strengthening market confidence in the banking system. The stress test identified 9 BHCs that met the capital requirements under the more adverse scenario and 10 that needed to raise additional capital. Nine of the 10 BHCs were able to raise capital in the private market, with the exception of GMAC LLC, which received additional capital from the U.S. Department of the Treasury (Treasury). The resulting capital adequacy of the 19 BHCs has generally exceeded SCAP's requirements, and two-thirds of the BHCs have either fully repaid or begun to repay their TARP investments. Officials from the BHCs, credit rating agencies, and federal banking agencies indicated that the Federal Reserve's public release of the stress test methodology and results in the spring of 2009 helped strengthen market confidence. During the first year of SCAP (2009), overall actual losses for these 19 BHCs have generally been below GAO's 1-year pro rata loss estimates under the more adverse economic scenario. Collectively, the BHCs experienced gains in their securities and trading and counterparty portfolios. However, some BHCs exceeded the GAO 1-year pro rata estimated 2009 losses in certain areas, such as consumer and commercial lending. Most notably, in 2009, GMAC LLC exceeded the loss estimates in multiple categories for the full 2-year SCAP period. More losses in the residential and commercial real estate markets and further deterioration in economic conditions could challenge the BHCs, even though they have been deemed to have adequate capital levels under SCAP. This report recommends that the Federal Reserve complete a final 2-year SCAP analysis, and apply lessons learned from SCAP to improve transparency of bank supervision, examiner guidance, risk identification and assessment, and regulatory coordination. The Federal Reserve agreed with our five recommendations and noted current actions that it has underway to address them. Treasury agreed with the report's findings.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: The Federal Reserve did not publish a comparison of the performance of the 19 largest bank holding companies against the more adverse scenario projections following the end of the 2-year period covered under the Supervisory Capital Assessment Program (SCAP). However, the Federal Reserve Board has decided to publicly disclose on an ongoing basis the actual and stressed performance of the largest 18 and 30 bank holding companies, starting with the 2013 annual Dodd-Frank stress test and the 2014 Comprehensive Capital Analyses and Review (CCAR), respectively. This ongoing disclosure of bank performance information is consistent with public statements made by members of the Federal Reserve's Board supporting more transparency regarding the financial condition of large, complex banking organizations in order to support market discipline and improved supervision. The Federal Reserve's actions effectively address the recommendation's intent that detailed institution-specific stress test results be made public. As a result of these actions, GAO considers this recommendation as implemented.

    Recommendation: To gain a better understanding of SCAP and inform the use of similar stress tests in the future, the Chairman of the Federal Reserve should direct the Division of Banking Supervision and Regulation to compare the performance of the 19 largest BHCs against the more adverse scenario projections following the completion of the 2-year period covered in the SCAP stress test ending December 31, 2010, and disclose the results of the analysis to the public.

    Agency Affected: Federal Reserve System

  2. Status: Closed - Implemented

    Comments: The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) required certain financial institutions to publicly disclose the summary results of stress testing performed by the institutions or the supervisor. In public statements by the Board's chair and a governor, the Federal Reserve has committed to expanding transparency of its supervisory process, building on the requirements of the Dodd-Frank Act. The Federal Reserve established in October 2012 expectations for transparency about methodologies used in a final rule about company-run stress tests required under the Dodd-Frank Act. The Federal Reserve noted the importance of having a consistent and transparent framework to support scenario design. To address this objective, the Federal Reserve defined different scenarios for the baseline, "adverse," and "severely adverse" economic conditions. The rule was coordinated with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. Furthermore, the Federal Reserve has progressively increased disclosure of firm-specific information, stress testing methodologies used, and scenarios. In 2012, Federal Reserve sought comments on its design framework for scenarios and incorporated them into a final document and has conducted an annual conference to obtain input from a wide range of stakeholders. In addition, it published in 2013 two separate reports that disclosed results of stress tests conducted per the Dodd-Frank Act and the Comprehensive Capital Analysis and Review (CCAR) for the "severely adverse" scenarios, and the subsequent annual reports in 2014 added the results under the "adverse" scenario (as well as the "severely adverse" scenario). As a result of these actions, GAO considers this recommendation as implemented.

    Recommendation: To leverage the lessons learned from SCAP to the benefit of other regulated bank and thrift institutions, the Chairman of the Federal Reserve in consultation with the heads of the FDIC and Office of the Comptroller of the Currency (OCC) should follow through on the Federal Reserve's commitment to improve the transparency of bank supervision by developing a plan that reconciles the divergent views on transparency and allows for increased transparency in the regular supervisory process. Such a plan should, at a minimum, outline steps for releasing supervisory methodologies and analytical results for stress testing.

    Agency Affected: Federal Reserve System

  3. Status: Closed - Implemented

    Comments: The Federal Reserve updated its supervision manual to include guidance to examiners for assessing the quality of stress tests conducted by bank holding companies. The manual now includes specific references to a May 2012 guidance, which describes elements of an effective stress test framework. The 2012 guidance was developed and released jointly with the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. Specifically, the guidance is intended to emphasize the importance of stress testing as an ongoing risk management practice that supports banking organizations' forward-looking assessment of risks and better equips them to address a range of adverse outcomes. In addition, the Federal Reserve has incorporated lessons learned from Supervisory Capital Assessment Review (SCAP) into its annual Comprehensive Capital Analysis and Review (CCAR) process. CCAR gives supervisors an opportunity to evaluate plans for capital distributions in light of the banking organizations' overall capital position under both baseline and hypothetical stressed conditions. It also provides a regular, structured, and comparative way to assess the capacity of these firms to manage their capital positions. CCAR annual reports include a description of the methodology used by examiners. In addition, in November 2013, the Federal Reserve, FDIC, and OCC jointly issued the economic and financial market scenarios used in the 2013 to 2014 stress tests and capital planning program. As a result of theses actions, GAO considers this recommendation as implemented.

    Recommendation: To leverage the lessons learned from SCAP to the benefit of other regulated bank and thrift institutions, the Chairman of the Federal Reserve in consultation with the heads of the FDIC and OCC should develop more specific criteria to include in its guidance to examiners for assessing the quality of stress tests and how these tests inform BHCs' capital adequacy planning. These guidelines should clarify the stress testing procedures already incorporated into banking regulations and incorporate lessons learned from SCAP.

    Agency Affected: Federal Reserve System

  4. Status: Closed - Implemented

    Comments: The Federal Reserve Board announced in April 2012 the formation of the Model Validation Council, consisting of independent experts. The council provides input on the Board's efforts to assess the effectiveness of the models used in the stress tests, improve the quality of the Federal Reserve's model assessment program, and strengthen the confidence in the integrity and independence of the program. In addition, the Federal Reserve has hosted since 2012 three annual conferences on stress tests, involving the participation of representatives from the Board and individual Reserve Banks as well as academics and bank holding companies. Discussions focused on the design and implementation of stress testing models and covered topics such as the relative merits of different modeling frameworks, best industry practices, and key challenges. As a result of these actions, GAO considers this recommendation as implemented.

    Recommendation: To leverage the lessons learned from SCAP to the benefit of other regulated bank and thrift institutions, the Chairman of the Federal Reserve in consultation with the heads of the FDIC and OCC should fully develop its plan for maintaining and improving the use of data, risk identification and assessment infrastructure, and requisite systems in implementing its supervisory functions and new responsibilities under the Dodd-Frank Act. This plan should also ensure the dissemination of these enhancements throughout the Federal Reserve System and other financial regulators, as well as new organizations established in the Dodd-Frank Act.

    Agency Affected: Federal Reserve System

  5. Status: Closed - Implemented

    Comments: The Federal Reserve, together with the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), developed and issued guidance in May 2012 on stress testing for large banking organizations. The guidance is intended to emphasize the importance of stress testing as an ongoing risk management practice that supports banking organizations' forward-looking assessment of risks. In addition, the Federal Reserve System, along with FDIC and OCC, developed and released in March 2013 an interagency guidance on leveraged lending. This guidance outlines high-level principles related to safe-and-sound leveraged lending activities. These principles include periodic loan- and portfolio-level stress tests on leveraged loan portfolios and incorporation of results into enterprise-wide stress testing activities. Finally, in December 2012, the Federal Reserve issued consolidated supervision framework for large financial institutions. The Federal Reserve states that building upon lessons learned from the recent financial crisis, it has taken a number of important steps to improve its supervisory program for large financial institutions. The 2012 framework sets forth a new approach for the consolidated supervision of large financial institutions, which recognizes that effective consolidated supervision requires strong, cooperative relationships between the Federal Reserve and other bank supervisors and functional regulators. The framework acknowledges the priority of horizontal examinations through the dedication of multidisciplinary skills and experienced staff. Examples include analysis of capital adequacy and planning via the Comprehensive Capital Analysis and Review (CCAR), as well as horizontal examinations of resolution plans and incentive compensation practices, which are conducted jointly with other bank supervisors. The framework also sets expectations that in developing and executing a detailed supervisory plan for each firm, the Federal Reserve should rely to the fullest extent possible on the information and assessments provided by other relevant supervisors and functional regulators. The framework also calls for the Federal Reserve to participate in interagency information sharing and coordination to promote comprehensive and effective supervision and limit unnecessary duplication of information requests. Finally, it encourages supervisory agencies to continue enhancing formal and informal discussions to jointly identify and address key vulnerabilities and to coordinate supervisory strategies for large financial institutions. As a result of these actions, GAO considers this recommendation as implemented.

    Recommendation: To leverage the lessons learned from SCAP to the benefit of other regulated bank and thrift institutions, the Chairman of the Federal Reserve in consultation with the heads of the FDIC and OCC should take further steps to more effectively coordinate and communicate among themselves. For example, ensuring that all applicable regulatory agencies are included in discussions and decisions regarding the development, implementation, and results of multiagency activities, such as horizontal examinations of financial institutions.

    Agency Affected: Federal Reserve System

 

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