Comprehensive Capital Analysis and Review (CCAR) is a regulatory framework governed by the Federal Reserve to assess, regulate, and supervise large US banks that are too big to fail. The global economic crisis/subprime crisis/recession of 2008 resulted in the economic collapse of some of the largest banks in the US. The government had to bail out financial institutions such as AIG and Fannie Mae.
CCAR is a set of requirements from regulators to oversee bank holding companies with average total assets of $50 billion. Requirements address capital adequacy, capital distribution, and capital planning process under base and stress economic scenarios.
CCAR is a kind of stress testing steered by the Federal Reserve board. Supervisory stress tests are an integral part of prudential regulations across the number of banks’ jurisdiction. The CCAR report provides a view on the industry facing economic risks, cyber risk, and emerging risks from financial technology companies as a whole and shows a comparison among different institutions.
So, what does the CCAR program evaluate?
A Do bank holding companies (BHCs) pose an adequate capital ratio? - As part of the annual CCAR review, the US Federal body will evaluate all US-based bank holding company’s capital ratios. BHCs must be mindful about showing capital structure distribution in their balance sheets.
B Is capital structure stable given the various stress-test scenarios? - The US Federal Reserve will provide BHCs with various stress-test scenarios. A stress test is used for micro- and macro-level validation. BHCs will consider stress scenarios and evaluate the capital structure. The objective of the FED here is to make sure that BHCs have adequate capital during economic crisis to avoid bailout situation.
C Are planned capital distributions viable and acceptable? - Capital distributions such as dividends distribution to shareholders and share repurchase either from existing shareholders or from exchanges should be planned per regulatory minimum capital structure requirements. US-based BHCs must suspend planned capital distribution to shareholders (corporate action events) in scenarios where the current capital balance is in deficit or the capital structure fails to comply per FED standards.
Stress testing scenarios
US Federal jurisdiction frames stress-testing scenarios and publishes them for BHCs every year. BHCs should consider these stress scenarios during capital analysis and review. The Federal Reserve releases annual CCAR scenarios in January and BHCs are expected to submit their capital plans and stress tests based on scenarios in April. BHCs implement a quarterly plan from July which includes distribution of excess capital, dividend payments, and share buyback as declared in the capital action plan.
Baseline scenario: It is a lightweight and usually simple scenario based on average projections of economic forecasters. This scenario considers current market and economic trends without expecting much volatility.
Adverse scenario: This scenario is placed above the baseline scenario and is slightly complex. This hypothetical scenario considers a moderate recession or mild deflation that might have a short-term effect on economy. An adverse scenario usually helps BHCs manage capital adequacy and plan better to distribute capital during short-term fluctuations in the economy.
Severely adverse scenario: BHCs will have a tough time working on severely adverse scenarios and this will give a true picture of the bank’s credibility to withstand long term economy crisis. This scenario includes hypothetical situations involving a severe global recession in the US, unemployment rates rising to 10%, corporates struggling with inadequate finance, borrowing outside markets becoming impossible, and US treasury securities yielding negative returns.
Components of CCAR
A Stress testing - As a part of stress testing, BHCs analyze and submit detailed income and balance sheet projections. They submit three Fed-specific scenarios (discussed above) and two internal scenarios at year-end. Banks also consider global market shock scenario and largest counterparty default scenario where applicable, capital ratios are projected over nine quarter planning horizon.
B Capital plan - BHCs set up an internal meeting and finalize the decision on capital plan/policy. As part of their internal process, they discuss and assess capital adequacy, and documentation plays a crucial role here. Extensive capital plan and planned capital actions over nine quarters are extensively documented. Documents usually consist of thousands of pages which are further utilized for audit and Fed regulatory purposes.
C Governance - BHCs have a governance body formed internally to make sure that each phase of CCAR is reviewed completely before reporting to FED. As part of governance, BHCs review a comprehensive stress testing framework, along with documentation and model validation. Stress testing results are reviewed by board members. Capital plan is reviewed by an internal audit after validating required controls. The governance committee will raise questions on several occasions and take quality time to evaluate all phases of CCAR. Multiple meetings are conducted to review documents, models, and stress testing results. This is considered as one of the crucial components as governance approval serves as a gate pass to further report the bank’s capital plan and results.
D Reporting - BHCs prepare for reporting the capital plan and results post approval from the governance committee. FRY 14A regulatory reports are prepared and reconciled to the FRY 9c report, model inventory mapping are performed on FRY–14 reports. Again, extensive documentation is maintained outlining the BHC procedures for meeting the accuracy requirements of reporting forms.
CCAR challenges for banks
There is no doubt that CCAR-eligible banks have come a long way. Financial institutions have implemented and enhanced their stress testing and capital planning process since its inception in 2009. This is evident from an increase in high-quality capital to risk-weighted assets of 34 BHCs which has doubled from 5.5% in 2009 to 12% in 2017. However, the broad and technical nature of CCAR regulatory framework challenges the banks to effectively comply with regulatory requirements. Below are a few of them:
Data Quality and Integrity
Availability of the firm’s key data for CCAR assessment is inconsistent. Also, stringent timelines of the CCAR cycle challenge banks to provide quality data for submission. Firms follow an estimation approach for CCAR access. This might be appropriate under expected conditions but not suitable for stress testing.
Internal Controls
Regulators expect CCAR banks to have a robust internal regulatory framework. However, many BHCs face challenges in remediating gaps in internal controls. Banks are expected to own, update, acknowledge, certify, and validate internal controls.
Unskilled/Non-technical Teams
Unfortunately, only few individuals within a bank understand the CCAR regulatory requirements which delays model documentation and scenario design. Banks are trying to implement a common language communicated across different business units and functions to achieve consistency.
Governance and Transparency
Financial institutions struggle to ensure transparency of process in board meetings. Any gaps and limitations in capital planning must be discussed among board members prior to approval. The board must be involved early in the CCAR cycle to understand any identified risk associated with products that might impact stress testing.
Attestation Enhancements
The Federal Reserve notifies shortfalls in the overall CCAR program through annual CCAR results. In this regard, banks should consider integration and enhancement of CCAR. CFO attestation is the final rule of the overall CCAR program. Banks should be mindful in considering attestation enhancement recommendations from the Fed and should implement in stringent timelines.
Future perspective of the CCAR regulation
On June 27, the US FED published results for CCAR 2019. It was positive news for all 18 participating banks where their respective capital plans on qualitative and quantitative grounds was approved. While banks have seen some reduction in stress capital requirements, they are still uncertain about evolving regulatory requirements for capital planning.
CECL Requirement 2020
Banks are grappling with new requirements, current expected credit losses (CECL) accounting standards and streamlining the CCAR process. CECL integration into CCAR is a top priority in 2020. One survey from McKinsey on the qualitative aspect of CCAR revealed that CECL will be the greatest area of focus for 2020 with 28% votes from banks followed by 21% on data quality and 20% on model risk management. PPNR model development is another prime area of focus for 2020. Banks are considering potential approaches for CECL integration, with few banks considering a coverage ratio approach.
Brainstorming and lot of thought processes are going around the industry on the treatment of CECL in the CCAR framework and on whether this should be considered as models or a qualitative approach. Banks need to identify the biggest drivers of losses, frame an approach for CECL/CCAR integration, and engage stakeholders across business lines in an iterative manner to refine approaches. The CECL model needs to integrate with CCAR considering data needs, production implication, and value impact.
CCAR Automation and Streamlining
Automating CCAR processes is a top priority in the near future, which will potentially help banks decrease CCAR budget allocations. In one survey conducted by McKinsey, 42% of banks voted in favor of prioritizing automation and streamlining processes, followed by integrating CCAR solution to business as usual and enhancing processes. 48% of banks voted in favor of cutting resources by 10%. Banks that have recently become subject to filing requirements generally have newer and more interconnected infrastructure.
Interestingly, few banks are now able to run stress tests in a few hours or days compared to six-plus weeks for some banks. Additionally, banks will continue work on CCAR governance processes, streamlining committees, and merging activities to reduce cycle times. As part of long-term initiatives, banks will target cloud-based workflow solutions that will enable connectivity and a successful run of model components. While automation requires upfront investment, it lowers cost in the long run. Banks can focus on higher value-added activities and the CCAR program, optimize portfolios, and assess potential deals and trades. Banks need to target high-cost areas such as running reports, documentation, and handoffs between workstreams.
CCAR Model Risk Management
Since models are at the heart of the stress testing program, model risk management (MRM) is the most important CCAR control. As part of future improvements, banks have to emphasize on qualitative model validations, study and enhancement of model limitations, and validating model standards across qualitative and quantitative scenarios. In order to identify and capture model errors early on, institutions will develop model risk management controls across the business, model risk management functions, and audit functions. Banks need to maintain standard models across all modeling teams and take complete ownership of their models. Banks need to maintain a well-defined framework for model validation. Framework should include a systematic way to understand risks and limitations of an individual model. Thus, model validation is of high importance as it detects errors in the process during model use and implications of errors. Therefore, validation teams play a key role here by focusing on testing the source of risk (data, framework, performance, governance) rather than following a generic testing plan.
Talent Management
Now that most of the banks have successfully built CCAR machinery, firms have an opportunity to assess which roles create the highest value and which are no longer required. Institutions should support talent rotation out of stress testing so that composition of the CCAR team is proactively managed. From a future perspective, banks will consider opportunities to bring together multiple disaggregated regulatory teams. Institutions will be able to identify parallel skillsets in multiple parts of the bank (analytical modeling, scenario development, and review).
Banks should reward people who can successfully manage and collaborate across reporting lines. For instance, they can recognize and reward people who can engage with the consumer retail banking team and the model validation team as this helps banks in analyzing the right datasets in modeling.
Banks should prioritize four key areas as mentioned below for an effective capital plan, error-free CCAR models, transparency, and risk among stakeholders and board members:
- Supervisory engagement and proposing approaches backed by the principle of sound risk management
- Balancing capital implications and responding to new requirements from FED rationally
- Exploring innovative ways to simplify the CCAR process and focus toward strategy and financial planning
- Optimizing portfolios to the right size of stress capital and managing capital allocation by considering a qualitative and quantitative approach
