I know you are staggering under the weight of the FRB’s new supervisory statement on how to score a passing grade in this year’s tough stress test. Now, for another rock in your rucksack: you will also need to model reputational, strategic, and compliance risk to see how they stress capital, run all this by your board, and then tell the FRB just what you’re going to do about it. For the first time, the Fed has rightly linked qualitative risks to quantitative performance measures. It has done so largely ahead of industry practice, thus establishing both new challenges and opportunities for legal, government-relations, and compliance officers not only at the largest BHCs, but also more generally across an industry seeking to institute best-practice capital planning.
The Fed is right – these risks way matter. For years, each was viewed by boards and senior management either as a political preoccupation or a cost-basis nuisance. I’m not sure that view has changed much, but recent experience makes clear that it surely should. Think, for example, about mortgage finance. Reputational risk? What has happened to the once rock-solid business line since the foreclosure crisis? Strategic risk is also there and then some – it’s simply impossible to project future revenue without taking carefully into account what is to come for Fannie Mae, Freddie Mac, FHA and the capital cost of portfolio lending. Compliance risk – again, a major concern, especially facing the new QM.
Mortgage finance may seem uniquely vulnerable to reputational, strategic, and compliance risk. But, it isn’t. Corporate finance – of course another bedrock business – is at risk in each of these arenas due to the pending risk-retention rules, liquidity standards, leverage-loan restrictions and other policy factors. Securities financing? It’s a business at risk of so radical a make-over as to threaten franchise value in yet another core sector for the largest banks. Commodities activities – yet again, a business at grave risk of a wholesale rewrite from on high. Foreign banks doing business in the U.S.? Don’t get me started on the new model that needs not just to be incorporated in capital planning, but also into forward-looking strategic planning. Historically, banks have waited for the death knell and then told the board. This comes in large part from the prime directive that seems to drive legal advisers – do nothing until you see the final fine print. Now, though, the FRB demands that these risks be forecast over the next nine quarters so that capital planning is corrected where revenues may be in for a redo. In essence, policy risk must be stress tested just like credit risk – waiting for reputational, strategic, or compliance risk to whack the bank in the face is poor risk management the Fed soon will sanction by putting the kibosh on capital distributions at laggard firms.
So, how to ensure that your BHC anticipates FRB demands and passes the stress test? A methodology can be found on our website (http://www.fedfin.com/info-services/issues-in-focus?task=weblink.go&id=69), along with the key sections in the FRB’s supervisory stress-test expectations that say it’s so. As you’ll see there, we think these stress tests for policy risk are a critical discipline not only for capital planning, but even more importantly for risk mitigation. Legal, government relations, compliance, and risk management have long played a vital role in anticipating strategic risk and redirecting resources – at least when the board and senior management pay attention. In the past, warnings could be discounted because costs were only qualitative; now, they must be translated into hard dollars by the BHC or the FRB will make you pay. Time, I think, for a rigorous review of risk in all of these sectors and quick action on meaningful mitigation.