Banking Performance Insights

2017 DFAST Scenarios: Historical Comparisons Can Affect Bank Forecasting

June 27, 2017


By Oleg A. Blokhin, David W. Keever, and Timothy J. Reimink

BPI DFAST
Now that regulators have released the 2017 Dodd-Frank Act stress-testing (DFAST) scenarios, banks are looking for opportunities to derive additional business value from the annual testing and compliance effort.


In February 2017, the FDIC released the economic and financial market scenarios that banks are to use for their 2017 stress-testing exercises, as required by Section 165(i)(2) of the Dodd-Frank Wall Street Reform and Consumer Protection Act. All banks with total consolidated assets of more than $10 billion are required to conduct annual DFAST exercises, which are designed to assess the forecasted impact that “future shock” scenarios would have on a bank’s financial statements. In addition, banks and bank holding companies with more than $50 billion in assets are required to perform a more extensive Comprehensive Capital Analysis and Review (CCAR), which is based on the same macroeconomic scenarios.

The objective of the DFAST and CCAR requirements is to identify capital and operating risks so that banks can maintain appropriate capital levels to mitigate the risk of failure. By recognizing and understanding annual changes in the DFAST scenarios and by reviewing trends from the first three years of DFAST activities, banks can better assess the adequacy of their capital planning and capital management systems. This analysis can help them confirm that these systems are fully aligned with the bank’s long-term vision and strategy.

Recent DFAST and CCAR Regulatory Developments

By the end of 2016, the number of banks covered by DFAST requirements – that is, banks with $10 billion to $50 billion in total assets – reached 61. In addition, another 33 banks and bank holding companies with more than $50 billion in assets were required to submit CCAR reports.

In 2016, DFAST marked its third submission year. With three years of experience and more clearly established expectations, banks and regulators began settling in. While five banks are new to the process, having surpassed the $10 billion threshold for the first time in 2016, most banks’ DFAST programs are now in their second or third years.

The results of 2016 DFAST and CCAR submissions will give some perspective on the industry. Among the 33 largest banks (that is, those with more than $50 billion in assets that are subject to CCAR requirements), all are expected to pass the quantitative portion of the submission, indicating they have adequate capital to withstand severe shock. These results were the case in prior years as well.

On the other hand, the qualitative portion of the CCAR assessment, which is designed to evaluate the strength of each company’s capital planning process, has been more challenging for some large banks. Based on recommendations in a November 2016 report by the Government Accountability Office (GAO), some large banks will be given some relief from this qualitative assessment requirement.

In January 2017, the Federal Reserve Board finalized a new rule that removes the CCAR qualitative assessment requirement for large and noncomplex firms. Qualifying institutions are bank holding companies and U.S. intermediate holding companies of foreign banking organizations with total consolidated assets between $50 billion and $250 billion and total nonbank assets of less than $75 billion, which are not identified as global systemically important banks (GSIBs).

The new rule provides relief to 21 of the 33 largest banks in 2017. These large and noncomplex firms still must meet the CCAR quantitative assessment requirements and are still subject to regular supervisory assessments that examine their capital planning processes. The remaining large and complex bank holding companies – including GSIBs – remain subject to both the qualitative and quantitative components of CCAR.

For banks with between $10 billion and $50 billion in assets, 2016 was a relatively successful submission year in terms of both the forecasts and overall program reviews associated with DFAST requirements. Nevertheless, regulators’ comments to many banks indicate examiners will continue to focus closely on several critical issues, looking for evidence that banks fully understand the risks of their portfolios and are modeling them appropriately. Issues of particular concern include exposure in the commercial real estate sector, the adequacy of model risk management and data governance policies, and internal audit programs.

2017 DFAST Scenarios

The 28 macroeconomic measures addressed in the DFAST scenarios have remained unchanged since 2015. Sixteen of these measures relate to future U.S. economic metrics, and there are three measures for each of four major U.S. international trading partners: the United Kingdom, Europe, Japan, and developing Asia.

Six of the U.S. measures relate to future economic activity and prices, six are interest rate measures, and four are aggregate measures of asset prices or market conditions:

DFAST Economic Activity Metrics

  • Real gross domestic product (GDP) growth
  • Nominal GDP growth
  • Real disposable income growth
  • Nominal disposable income growth
  • Unemployment rate
  • Consumer price index (CPI) inflation rate
DFAST Interest Rate Metrics
  • 3-month Treasury rate
  • 5-year Treasury yield
  • 10-year Treasury yield
  • BBB corporate yield
  • Mortgage rate
  • Prime rate
DFAST Asset Prices/Market Conditions
  • Dow Jones total stock market index
  • Housing price index
  • Commercial real estate (CRE) price index
  • U.S. market volatility index (VIX)

While the measures themselves have remained consistent for the past few years, the specific numbers assigned to these variables under the three scenarios – baseline, adverse, and severely adverse – have changed. The general economic conditions in each of the 2017 scenarios are summarized in the following exhibit:

Exhibit: DFAST Scenario Summary

  2017 Baseline Scenario 2017 Adverse Scenario 2017 Severely Adverse Scenario
General Description Moderate expansion Moderate recession Severe global recession, heightened stress in corporate loan and CRE markets
GDP Growth Real GDP grows at average rate of 2.25% per year Real GDP drops to -2.8% in Q2 2017, recovering to 2.6% by Q1 2019 Real GDP growth is negative throughout 2017 and Q1 2018 before recovering to 3.0% in Q1 2019
Equity Prices Equity prices rise an average of 5.0% per year Equity prices decline; Dow decreases 40% before gradually increasing in 2018 Equity prices decline; Dow decreases 50% before gradually increasing in 2018
Interest Rates Short- and long-term Treasury yields rise steadily Short-term rates fall and remain near zero (0.1%); long-term Treasury yields gradually rise Short-term rates fall and remain near zero (0.1%)
Unemployment Gradually declining unemployment to 4.5% by Q1 2019 Unemployment increases, peaking at 7.3% in Q3 2018 Unemployment increases, peaking at 10.0% in Q3 2018
Inflation Gradually decreasing CPI inflation to near 2.3% by Q1 2019 Inflation remains low Inflation remains well below 2.0%

Source: Crowe analysis of 2017 Federal Reserve DFAST Supervisory Scenarios

By comparing some of the 2017 scenario details with comparable details from the 2016 scenarios, it is possible to understand where regulators’ concerns and interests are focused. For example, the 2017 severely adverse scenario is premised on an even deeper worldwide recession than was used in 2016. The 2017 severely adverse scenario projects a particularly deep recession in Japan, with recovery not beginning until mid-2019 and deflation carrying through until early 2020.

The 2017 severely adverse scenario also is based on a massive 45 percent drop in equity prices, along with a 33 percent drop in the CRE pricing index by September 2018. This is consistent with the way regulators in the field continue to focus on CRE portfolios, sending a clear message to banks that CRE exposure remains a top regulatory concern.

Looking Ahead

As mentioned earlier, the rules changes announced in early 2017 in conjunction with the release of the 2017 scenarios already are having an impact on large, noncomplex banking organizations that have been relieved of some CCAR compliance burden. In addition, there continues to be considerable discussion among legislators and regulators about modifying or rescinding other aspects of the Dodd-Frank Act.

Current assessments of the potential timing and scope of additional Dodd-Frank revisions tend to envision changes occurring over a period of several years, generally focusing on revisions rather than repeal. The eventual outcome of these efforts will not be known for some time, but the continued possibility of additional regulatory relief means even experienced DFAST submitters should be alert to possible changes.

For banks that are just now approaching the $10 billion threshold, the possibility of further changes in the regulatory landscape adds another element of uncertainty. Individual circumstances vary, of course, but broadly speaking, banks in this situation eventually must choose one of three alternative strategies:

  1. Slow their growth to stay below the threshold until the future direction of regulation becomes clearer.
  2. Cross the $10 billion threshold through organic growth and absorb the considerable new compliance costs.
  3. Leap across the threshold through merger or acquisition, in hopes of absorbing the additional compliance costs more effectively.

Regardless of size, modeling remains a critical concern for all banks. Regulators have made it clear they want to further understand how model risk governance is being implemented as part of the model development and validation process.

The coming years also will require continued improvements in data management since the reliability and accessibility of data are critical not only for DFAST compliance but also for credit loss modeling, financial reporting, and general capital planning purposes. The adoption of the current expected credit loss (CECL) model for calculating the allowance for loan and lease losses (ALLL) calculations provides additional opportunities for integrating data management tools and systems even further.

Banks that are just now initiating their DFAST planning efforts are strongly encouraged to integrate the planning for CECL with that effort. Banks that are beyond the planning stages and already engaged in DFAST reporting should consider aligning their annual DFAST program with their CECL road map planning.

Historically, these two expected loss estimates have been disconnected and isolated in use and application, but converging the data, modeling, documentation, and production of these estimates offers obvious benefits in terms of efficiency, cost-effectiveness, and overall business value.

One key to the successful integration of these programs – and, for that matter, to the successful implementation of DFAST compliance overall – is effective board and management oversight. Board members and senior executives must meet well-defined governance and oversight responsibilities, including the responsibility to understand, analyze, and effectively challenge the relevant forecasts.

But in addition to meeting regulator expectations and scrutiny, boards and executive teams also should carry through with a concerted effort to connect stress testing to broader business purposes. By understanding the DFAST scenarios and applying their findings toward other forecasting and capital planning purposes, bank leadership teams can develop a more comprehensive and responsive picture of the bank’s long-term earnings and capital position.

Authors
Oleg Blokhin
keever-dave-150
Dave Keever
Principal
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Tim Reimink
Managing Director