Navigating the changing landscape: the importance of ongoing capital stress testing in the banking industry

The Federal reserve and Capital Reform

The Federal Reserve released this year's supervisory stress testing results in June. The tests revealed that the participating institutions exceeded the required capital levels in the stress test scenario despite facing higher credit and corporate losses than in the past. These results are significant as they come at a time when the regulatory framework for banking capital is changing.

The bank capital reform the Federal Reserve proposed last year is expected to increase regulatory capital requirements and apply stringent capital requirements to a broader set of institutions with over $100 billion in assets. The proposal faces heavy opposition from the banking industry, which has cited the forward-looking impact on the cost and availability of financial products. The Fed's announcement of "broad and material changes" in response to feedback has added an element of uncertainty regarding the timing and scope of the changes, which could range from adjustments to the original draft to a new proposal altogether. It is also unclear if the final rule will be finalized before the November elections. Capital reform is a complex and highly debated issue, and it typically takes a significant amount of time for legislation to be proposed, debated, and passed. Despite this uncertainty, institutions should not overlook the importance of capital stress testing in their risk management function. As risks to capital continue to evolve, ongoing capital stress testing and a broader set of adverse scenarios beyond regulatory requirements are essential to ensuring resilience in the face of potential challenges.

Sources of Capital Risk

• Capital stress testing serves as a comprehensive risk management exercise that evaluates various areas where hypothetical risks can converge to affect income and balance sheets. While institutions have been bolstering their capital since the 2007-09 financial crisis, potential risks to capital in the current environment can arise from different sources, including:
• Credit risk: Delinquency levels in consumer and commercial real estate loans have increased, resulting in decreased profitability and prompting some institutions to raise their allowance for loan losses. The Federal Reserve is closely monitoring credit conditions.
• Interest rate risk : Fixed-rate portfolios are still experiencing significant unrealized losses as interest rates remain higher for longer.
• Funding risk: Although deposit levels have stabilized and funding pressures have eased since a few banks failed in 2023, many institutions have turned to wholesale funding, leading to increased funding costs and putting pressure on net interest margins.
• Operational risk : Cybersecurity risk is particularly high, especially in the age of artificial intelligence.

Capital stress testing framework

Capital stress testing helps institutions gain a better understanding of their weaknesses and ability to withstand challenges - it should not be seen as a "check-the-box" exercise. Crafting internal stress scenarios with layers of idiosyncratic risks that are tailored to the institution's risk profile enhances stress testing's effectiveness. A well-constructed stress testing framework and methodology help identify risks, assess vulnerabilities, and define mitigation strategies:

• Identifying risks : This involves pinpointing specific risks and macroeconomic variables relevant to the institution, such as credit events, market volatility, and concentration risks. The selection of these risks should inform the development of stress scenarios, either through internal generation or by adopting scenarios from external providers that closely mirror the institution's risk profile.
• Assessing vulnerabilities : This can reveal potential risks from both direct and indirect stress impacts, which is crucial since stress events can trigger not only capital strain but also liquidity issues or other forms of stress given the interconnected nature of these risk domains.
• Designing mitigation strategies : Making strategic decisions can strengthen an institution's capital position through a detailed capital contingency plan. This plan should include clearly outlined capital triggers, a wide range of actions to address issues, feasibility evaluations, and alignment with the organization's approved capital risk appetite set by its board.
• Assessing capital adequacy : Establishing internal capital benchmarks that align with the institution's risk appetite is vital. Regulatory authorities utilize this aspect of stress testing in their supervisory stress tests to establish suitable capital requirements for larger organizations.

In conclusion, while the regulatory stress testing cycle for this year may have ended, the need for continuous capital stress testing remains pertinent. By identifying risks and incorporating relevant macroeconomic scenarios and idiosyncratic risks, institutions can better assess their capital adequacy and identify potential problems on their balance sheets. As regulatory changes loom on the horizon, organizations should continue performing capital stress testing and remain proactive in monitoring and addressing risks to their capital adequacy. By leveraging stress testing as a strategic tool to identify and quantify risk, institutions can navigate today's complex financial landscape with confidence and resilience.