Kbra financial institutions for bond investors the bank stress test process is beside the point

U.S. Financial Institutions FI Research

For Bond Investors, the Bank Stress Test Process is Beside the Point Summary It is time once again for the Dodd-Frank Act Stress Test (DFAST) and the related Comprehensive Capital Analysis and Review (CCAR) stress tests conducted by the Board of Governors of the Federal Reserve System. The good news is that all of the participating banks passed at least the DFAST round. The bad news is that DFAST and CCAR tell investors nothing about the safety and soundness of large banks and the markets in which they operate.

The Fed’s stress test process has become a media and investor relations circus, with Fed economists in Washington running a centralized and secretive process without any input from regional Federal Reserve Banks1 and contains little or no value in terms of prudential regulation of banks. Indeed, the Office of Financial Research notes in a paper that the Fed’s stress test process has become entirely “predictable” and that the results are “nearly perfectly correlated.” 2 The first observation that must be made about DFAST and the related CCAR process is that the stress tests have little to do with assessing the systemic stability of large U.S. banks. For bond investors, Kroll Bond Rating Agency (KBRA) notes, DFAST and CCAR are almost irrelevant.

Equity investors, however, are fixated on the latter because the Fed stress tests ultimately determine share buybacks and dividends. Senior bank managers are also keenly focused on CCAR because failure can lead to reduced compensation or even termination.

While the first Fed stress tests conducted by the Fed in 2009 served some purpose in terms of reassuring investors that U.S. banks were sound, the subsequent DFAST exercise mandated by Congress has become part of the erroneous narrative adopted by the G-20 nations that says a lack of capital inside the banks in the major industrial nations was the cause of the 2008 market break. As KBRA has noted in several research notes over the past year, adequate capital is not the issue. The cause of the 2008 market break was the unrestrained creation of bad securities in “off-balance sheet” (OBS) vehicles and related acts of securities fraud.

Bad acts in the securities markets led to a precipitous decline in investor confidence in 2007, leading to a well-documented run on liquidity that adversely affected large banks such as Wachovia Bank, Citigroup (NYSE:C) and even the housing GSEs, Fannie Mae and Freddie Mac. “What are they assuming happens in that default? What are they assuming about contagion?” said Anat R. Admati, a professor of finance and economics at Stanford, in an interview with The New York Times. “It takes a leap of faith to feel safe because of these tests.”

Much to the detriment of investors and the public in general, nobody in Washington – in Congress, among the financial regulators, or in the policy community – is focused on the issue of OBS finance and how it contributed to the financial crisis. By 2008, OBS abuses amounted to about $30 trillion in the U.S. and $60 trillion worldwide, a huge amount of bad debt that continues to hurt investor confidence, and retard capital formation and economic growth.3 1

See Jon Hilsenrath, “Washington Strips New York Fed’s Power,” The Wall Street Journal, March 5, 2015 See John Heltman, “Fed Stress Tests Are Too ‘Predictable,” OFR Says,” American Banker, March 5, 2015 3 See Frederick Feldkamp and Christopher Whalen, “Financial Stability: Fraud, Confidence & the Wealth of Nations,” John Wiley & Sons, 2010 2

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Congress responded to grotesque acts of securities fraud committed by Enron and World Com in the 1990s with the 2002 Sarbanes Oxley legislation, which increased requirements with respect to corporate governance and reporting for public companies. The 2010 Dodd Frank legislation likewise embraces the idea that requiring more capital in banks can somehow offset the illeffects of concealing tens of trillions worth of OBS liabilities from investors. By pretending that these OBS transactions were valid as “sales” under GAAP, U.S. regulators set the stage for the collapse of firms like Lehman Brother, Bear, Stearns & Co and Citigroup, to mention just a few.

"Higher capital levels at large banks increase the resiliency of our financial system," Federal Reserve Governor Daniel K. Tarullo said in the Fed statement. "Our supervisory stress tests are designed to ensure that these banks have enough capital that they could continue to lend to American businesses and households even in a severe economic downturn." But of course, no amount of capital can suffice to protect financial institutions and markets if the major banks are allowed to conceal liabilities via OBS transactions.

The whole notion of “off balance sheet liabilities” is an oxymoron. Why is any liability an “off balance sheet” and, if it is an “off balance sheet,” why is it a “liability”? Nobody at the Fed, or other regulatory agencies, it seems, can answer that question. Since the 1980s, financial regulators in the U.S. and the UK have acquiesced in the issuance of OBS liabilities by major banks as a way of boosting earnings by creating greater effective leverage in the financial system and thereby driving short term credit creation and growth. But it is pretty clear, in our view, that the cost of such practices far outweighs the short-term growth achieved. Just consider the trillions of dollars in losses to investors due to the 2008 financial break.

Not only does the DFAST and CCAR ignore the potential impact of concealed OBS exposures on large banks, but also the Fed uses the absurd concept of “risk weighted assets” (RWA) from the Basel III framework as the basis for measuring on-balance sheet capital levels and leverage.

Naturally RWA is easily manipulated, but the larger issue is that the bias of the Basel III capital framework system favors obligations of government and GSEs and discriminates against private assets. Thus, the largest banks manage metrics such as RWA by loading up on government debt to show the minimum amount of private sector risk, while using OBS vehicles and derivatives to conceal private credit exposures that have the highest capital risk weight under Basel III. Another aspect of the FAST and CCAR process that KBRA finds troubling is the use of an economic narrative to frame the capital adequacy simulation. The Fed provides banks with pages of economic variables that the management is supposed to use as part of their loss modelling effort, a process that can take upwards of three months. As the Fed noted in its press release: “This is the fifth round of stress tests led by the Federal Reserve since 2009 and the third round required by the Dodd-Frank Act. The 31 firms tested represent more than 80 percent of domestic banking assets. The Federal Reserve uses its own independent projections of losses and incomes for each firm.”

By injecting subjective economic scenarios into a test of loss absorption capacity, the Fed renders the output meaningless from a safety and soundness perspective. The various economic variables make the process so subjective and so speculative that the objective of measuring the capital adequacy of the bank is lost. Measuring the ability of a bank to absorb loss via retained

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earnings and capital is a straight-forward exercise that the Fed has needlessly complicated to the point of irrelevance.

Finally, perhaps the most telling comment that needs to be made about DFAST and the CCAR is the amount of time and money that banks need to spend in responding to the Fed’s hypothetical scenarios. The entire DFAST and CCAR process is opaque. The Fed refuses to provide banks with the most basic information about the DFAST and CCAR evaluation process, but expects each institution and its board of directors to spend between two to three months each year engaged in an economic modelling and financial self-evaluation process.

First, banks are required to perform an exhaustive self-analysis of financial and operational risks that most closely resembles a full-blown audit. Management and the board of directors are required to comprehensively identify all risks to the enterprise, then model hundreds of variables in response to the subjective criteria provided by the Fed. The banks are required to design their own internal economic scenarios and then stress credit, operational and idiosyncratic risks. Keep in mind that for many banks, there are more people working on DFAST and CCAR than are part of the core credit team.

Banks must then engage in their own economic modeling exercise and relate this output to the bank’s financials. The management and board members of the bank are required to be involved in this process from start to finish, leading KBRA to ask a simple question: who is managing the bank during the three months required to assemble a response to the Fed’s stress test requirements? Management and the risk committee of the board is involved in every aspect of preparing the response and is, of course, aided by dozens of outside lawyers, economists and consultants. The final output stretches into thousands of pages and includes capital levels, credit losses in multiple categories of loans and securities, and projections for pre-tax and preprovision revenue, among other things.

When the bank submits the stress test results, the Fed shows up with dozens of people from the Division of Supervision and Regulation to review the response. In almost every case, the Fed’s internal modeling of the institution is more severe than the bank’s own modeling, forcing the bank to constantly look over its shoulder in an effort to anticipate how much the Fed’s own results will overshoot the bank’s internal model. Fed Vice Chairman Tarullo has said that regulators do not want banks to “manage to model,” but that is precisely what the DFAST and CCAR process is causing banks to do today.

In the most recent DFAST results, some of the subjectivity of the Fed’s process is apparent.

Curiously, Goldman Sachs (NYSE:GS) is estimated to lose about the same as Bank of America (NYSE:BAC) in a global market stress scenario, a highly unlikely outcome, in our view, if you understand the business models of these two very different institutions.

Another incongruous result is the worse than average loan loss rate estimated for US Bancorp (NYSE:USB). Given the outstanding credit performance of USB during and after the 2008 crisis, one wonders: Does the Fed take proper loan underwriting and "know your customer" into account? Does the Fed staff really believe that USB would experience higher C&I loan losses than its larger TBTF peers?

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Overall, the tests do not seem to take into account the track record and skill of management teams. Some executive teams are simply better at navigating through stressful periods, given greater knowhow and adaptability combined with superior systems, controls and discipline.

Conclusion The Fed is required by the Dodd-Frank Act to conduct annual stress tests on large, systemically significant banks. However, the central bank has created a process that is opaque to banks, investors, and the public at large. KBRA publishes financial strength ratings on every U.S. bank using publicly available data that is both transparent and consistent. We believe that the banking industry, investors, and the public would be better served with an annual stress test process that is clearer and based upon public data, does not depend upon subjective economic scenarios, and is easily comparable between institutions.

The Fed has created a process that is prohibitively expensive for banks, produces little in the way of useful information for investors, and has almost no value in terms of public policy.

KBRA’s financial strength and issuer ratings for banks help investors understand risk, but the DFAST and CCAR tests seem to have little utility other than imposing increased cost and management distraction for large banks. With all due respect to Governor Tarullo and our esteemed colleagues at the Fed, KBRA believes that we can do a better job of assessing the capital position of our nation’s largest and most important banking institutions.

Analytical Contacts: Christopher Whalen, Senior Managing Director cwhalen@kbra.com, (646) 731-2366 Joe Scott, Senior Director jscott@kbra.com, (646) 731-2438

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