On Wednesday, the FRB did what it said it would last August and sanctioned four BHCs found wanting under the stress test not in capital adequacy, but rather in governance. For all their benefits, stress tests until now have been pin-the-tail-on-the-donkey exercises – hit the number, win a dividend. I, among others, have been critical of this because matching capital point to the basis point of the Fed’s demands doesn’t necessarily mean a big BHC is safe and sound – all it tells you for sure is that it’s darn good not only at modelling, but also at doping out its supervisor. We can argue all day about whether the Fed gave everyone enough notice or is sufficiently transparent, but the critical take-away from this year’s CCAR is that boards and senior management can’t just listen to the number-crunchers.
This year’s CCAR went far beyond prior ones by requiring that the board take all the scenarios and the numbers they spit out and, then, put them into a broader context. This one must assess operational, reputational, strategic, compliance and other risks not included in the supervisory scenarios. Critically, the board is to ensure that forward-looking planning anticipates the impact not just of rules now in place, but also of those to come. Banks are often unwilling to take action until a rule is final because of lingering uncertainties, but often the broad parameters of a rule and its strategic impact are visible even if counsel is still counting footnotes. FBOs that flunked CCAR are a case in point about the critical importance of advance stress testing for likely – not certain – regulatory action.
How does one do forward-looking strategic planning in the midst of continuing regulatory uncertainty? How-to suggestions can be found at http://www.fedfin.com/images/stories/client_reports/Risk%20Analytics%20Paper%20-%20September%202013.pdf. This landscape approach matches current and desired business lines against policy parameters and then maps these out. For example, if a bank has big plans for foreign correspondent lending, it maps out the impact of AML requirements to determine if the business can progress as planned. If not, income from it is revised in the numerical part of the test. If a bank plans big leverage-loan activities, the guidance now and sanctions to come are captured and business again adjusted as warranted. Margin requirements for securities financing are captured even though not now required, with capital in the out-quarters adjusted, and so forth across the spectrum of material business lines and major rules at home and abroad.
When we put out the planning guide referenced above last year, I talked it over with senior management at a large BHC. Ultimately, they decided they didn’t need to undertake this board exercise because they were confident that their risk architecture was wondrous to behold. Not so much, since this BHC flunked. One of the BHCs that passed to my knowledge did undertake a strategic planning exercise capturing the non-credit, market-, and interest-rate risks expressly stipulated in the supervisory models, winning the power to make capital distributions despite relatively low capital ratios.
Is this easy? Of course not. Does it force business units to confront constraints not of their making and thus not to their liking? Yes. But, is it the board’s responsibility to understand the risks and, yes, opportunities in the policy environment and, then, to ensure the BHC is ready? Again, yes. Indeed, this is vital not just to pass the stress test, but also to gain first-mover advantage. In a regulated business, knowing what is about to befall your BHC or a competitor is critical business intelligence.