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A version of this article for community banks appeared in the December 2014 issue of the Invictus Bank Insights newsletter.
In November, the Federal Reserve released macroeconomic scenarios for banks with more than $50 billion in assets, which are required to submit capital stress tests under the Comprehensive Capital Analysis and Review program. Each year, the Fed adds a unique twist to these scenarios, a twist that can provide insights into regulatory priorities for all financial institutions. Smart credit unions should understand what regulators are thinking, and use that knowledge to get ahead of both their competitors and examiners.
Here are a few key takeaways from the CCAR 2015 scenarios that credit unions may benefit from following:
1. Regulators are worried again about a bubble forming in both residential and commercial real estate prices. The declines simulated in the “Severely Adverse” case scenario are steeper than when the CCAR program began.
Credit unions should be able to demonstrate how their mortgage portfolio will perform under a multitude of scenarios. A loan review approach will not cut it. While loan review—the categorization of loans into appropriate classifications, Allowance for Loan and Lease Losses analysis, and the documentation review—is important, it is not a stress test. Similar to traditional balance sheet or call report analysis, loan review is based on historical and current environments. Stress testing is the only forward-looking way to evaluate the performance of loans in different economic environments and determine their impact on capital adequacy.
2. The Fed has introduced a new interest rate risk test – and it includes a mini-recession. This is the jaw-dropper this year, although the Fed did hint this was coming in the last two CCAR stress tests. While the regulatory focus with the CCAR banks has been – and will continue to be – the Severely Adverse Case scenario, the milder Adverse Case scenario now includes a massive increase in both short- and long-term interest rates, a flattening yield curve, as well as rising inflation.
Many credit unions have been thinking for a while that they will benefit when interest rates return to normal, assuming they will just make more loans at the higher interest rates and higher spreads. While this is probably true for the largest banks because they have the sophistication and the hedging strategies in place, many smaller financial institutions continue to take false comfort in their asset/liability models.
Regulators didn’t have the data to push back against the ALM models, but they have found an alternative solution: Have the banks perform interest rate risk assessments in the face of a modest economic recession. This has many ramifications.
First, it will limit, if not eliminate, the offset of making new loans at higher interest rates. Second, the increase in debt service for many floating rate loans will lead to spikes in defaults since borrowers’ cash flows would be squeezed on both ends.
The Fed may also be using this information to do its own strategic planning. Remember, the situation it is in is unprecedented, and it will be difficult for the regulators to manage an increase in interest rates with an improving economy, while both inflation and deflation remain non-issues.
Will this scenario be required for credit unions? Probably not. But if you were a director sitting on a credit union board, wouldn’t you want to know how your organization would handle this scenario? Could you think of a better risk management analysis given the current economic climate? Is there a more practical “worst case” scenario that banks are facing today?
3. Although the regulators don’t say it, the Adverse Case scenario is also a disguised liquidity stress test. Check out this quote from the Fed’s instructions for 2015: “…firms should interpret the rise in short-term interest rates embodied in this year’s adverse scenario as crystallizing certain risks to banks’ funding costs.
To sum it up: The lessons smaller institutions can learn from the CCAR 2015 stress scenarios are not about scare tactics, regulatory requirements coming down the pike, or best practices in enterprise risk management. Your regulator may never even broach these topics with you. This is about reading between the lines and positioning your credit union to take advantage of these scenarios, so that if they do occur, you can stay competitive.
Adam Mustafa is a co-founder of Invictus Consulting Group and has been providing stress testing and capital adequacy advisory services to banks, regulators, bank investors, and bank D&O insurers since the beginning of the financial crisis. Mustafa has overseen the design and implementation of fully-customized capital stress testing, capital management, and strategic planning systems for community banks ranging from under $100 million in assets to Dodd-Frank banks that have in excess of $10 billion in assets.
