Dodd-Frank Act Two-Year Anniversary
Five takeaways on Dodd-Frank impact on stress testing
As we approach the two-year anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), it’s worth pausing for a moment to take stock of how it has already influenced the financial services and banking industries, and what may lie ahead. Today, its full impact remains to be seen – financial services institutions are still grappling with the enormity and complexity of the 2,300-page law. And federal regulators are still writing many of the rules that will affect different corners of the industry, contributing to continued uncertainty. Even though many of the rules are just now becoming final and with many more to be written, the impact of the legislation can be felt in areas such as stress testing.
Up to this point, the stress testing exercise has been an annual Federal Reserve requirement that first applied to 19 of the largest holding companies, known as the Comprehensive Capital Analysis and Review (CCAR), and then was expanded to most holding companies with assets greater than $50 billion, known as the Capital Plan Review (CapPR). The submissions require three economic scenarios – baseline, adverse under a supervisory scenario, and an adverse under an idiosyncratic scenario developed by the institutions. The idea is that financial institutions should be able to withstand economic stress as they continue to lend and maintain sufficient levels of capital. The Federal Reserve Board is overseeing the stress testing and results are being publicly disclosed. However, these stress-testing requirements are having a big impact on institutions in areas ranging from forecasting capabilities and data integrity to governance and beyond.
While the larger CCAR institutions tend to have the modeling capabilities along with three years of experience under their belt, the CapPR institutions tend to have limited data capabilities and little or no modeling capabilities. One of the most significant challenges for the CapPR institutions is being able to translate economic stresses in a manner that is predictive of losses on their balance sheet. They also may not have the governance processes in place that larger institutions have that are farther along in the internal capital adequacy assessment process.
For banking executives working to understand where they should be focusing when it comes to stress testing issues in the age of Dodd-Frank, here are five important observations.
Forecasting models should consider macroeconomic variables
Financial institutions should consider the need for appropriate loan-level models capable of forecasting losses. Loss forecasts from these models should consider macroeconomic variables of the economic scenarios.
Data requirements are more stringent
A key challenge facing many institutions is the requirement to capture and provide more granular data across different exposure types. Additionally, institutions need to consider whether the quality of data that they provide needs to be enhanced. Bad data or gaps in the data can compromise regulatory expectations on the stress testing process.
Governance should address the whole system, not just parts
Many institutions could improve their governance structures and controls to oversee data integrity, models used in stress testing, and validation of the models. They may need to develop governance policies, procedures, and processes, but also bring in additional specialists or consultants to support their efforts. In addition, an institution’s board of directors should consider the nature of the information that they receive. Is it timely and clear? Does it cover the various business activities? How does it provide information on the impact on capital to make informed decisions? This may pose a larger problem for smaller institutions than larger ones.
Institutions should consider a capital assessment process
Institutions may need to develop a robust, well-documented internal capital adequacy assessment process, which helps them identify and measure all material risks, establish internal capital targets, and outline the role of board and senior management in their oversight of the capital assessment process.
Ensure alignment of reported numbers among the call reports and business line MIS
Frequent differences between regulatory definitions and accounting definitions can contribute to numbers that may appear to be unaligned from report to report. Reconciling these differences can require a time-consuming manual adjustment process. Institutions that bring these definitions into alignment from the start may be able streamline the stress testing process.
Because there’s a lot more to know about the Dodd-Frank Act, these takeaways are presented as part of a series of issue-focused insights into the impact of this legislation. In the coming days, Deloitte will release a more in-depth look at the law’s potential implications in other areas such as consumer protection, derivatives, the Volcker rule, and living wills. For more information, please visit us at Financial Regulatory Reform.
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