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2,500 | ives a BHC greater permanent loss absorption capacity and greater ability to conserve resources under stress by changing the amount and timing of dividends and other distributions. To protect against risks, financial regulators set minimum standards for the capital that firms are to hold. However, SCAP set a one-time minimum capital buffer target for BHCs to hold to protect against losses and preprovision net revenue (PPNR) that were worse than anticipated during the 2009 to 2010 period. For the purposes of |
2,501 | SCAP, the one-time target capital adequacy ratios are at least 6 percent of risk-weighted assets in tier 1 capital and at least 4 percent in tier 1 common capital projected as of December 31, 2010. For the purposes of the projection, the regulators assumed that BHCs would suffer the estimated losses and earned revenues in 2009 and 2010 in the more adverse scenario. SCAP regulators conducted the stress test strictly on the BHCs’ assets as of December 31, 2008, and—with the exception of off-balance sheet pos |
2,502 | itions subject to Financial Accounting Statements No. 166 and 167, which assumed in the analysis to come on balance sheet as of January 1, 2010—did not take int account any changes in the composition of their balance sheets over the year time frame. Stress testing is one of many risk management tools used by both BHCs and regulators. Complex financial institutions need management information systems that can help firms to identify, assess, and manage a full range of risks across the whole organization arisi |
2,503 | ng from both internal and external sources and from assets and obligations that are found both on and off the BHC’s balance sheet. This approach is intended to help ensure that a firmwide approach to managing risk has been viewed as being crucial for responding to rapid and unanticipated changes in financial markets. Risk management also depends on an effective corporate governance system that addresses risk across the institution and also within specific areas, such as subprime mortgage lending. The board |
2,504 | of directors, senior management, audit committee, internal auditors, external auditors, and others play important roles in effectively operating a risk management system. The different roles of each of these groups represent critical checks and balances in the overall risk management system. However, the management information systems at many financial institutions have been called into question since the financial crisis began in 2007. Identified shortcomings, such as lack of firmwide stress testing, have |
2,505 | led banking organizations and their regulators to reassess capital requirements, risk management practices, and other aspects of bank regulation and supervision. Stress testing has been used throughout the financial industry for more than 10 years, but has recently evolved as a risk management tool in response to the urgency of the financial crisis. The main evolution is towards the use of comprehensive firmwide stress testing as an integral and critical part of firms’ internal capital adequacy assessment p |
2,506 | rocesses. In the case of SCAP, the intent of the stress test was to help ensure that the capital held by a BHC is sufficient to withstand a plausible adverse economic environment over the 2-year time frame ending December 31, 2010. The Basel Committee on Banking Supervision (Basel Committee) issued a document in May 2009 outlining several principles for sound stress testing practices and supervision. The Basel Committee document endorses stress testing by banks as a part of their internal risk management to |
2,507 | assess the following: Credit risk. The potential for financial losses resulting from the failure of a borrower or counterparty to perform on an obligation. Market risk. The potential for financial losses due to an increase or decrease in the value of an asset or liability resulting from broad price movements; for example, in interest rates, commodity prices, stock prices, or the relative value of currencies (foreign exchange). Liquidity risk. The potential for financial losses due to an institution’s failu |
2,508 | re to meet its obligations because it cannot liquidate assets or obtain adequate funding. Operational risk. The potential for unexpected financial losses due to a wide variety of institutional factors including inadequate information systems, operational problems, breaches in internal controls, or fraud. Legal risk. The potential for financial losses due to breaches of law or regulation that may result in heavy penalties or other costs. Compliance risk. The potential for loss arising from violations of laws |
2,509 | or regulations or nonconformance with internal policies or ethical standards. Strategic risk. The potential for loss arising from adverse business decisions or improper implementation of decisions. Reputational risk. The potential for loss arising from negative publicity regarding an institution’s business practices. According to SCAP regulators and many market participants we interviewed, the process used to design and implement SCAP was effective in promoting coordination and transparency among the regul |
2,510 | ators and participating BHCs, but some SCAP participants we interviewed expressed concerns about the process. The majority of supervisory and bank industry officials we interviewed stated that they were satisfied with how SCAP was implemented, especially considering the stress test’s unprecedented nature, limited time frame, and the uncertainty in the economy. SCAP established a process for (1) coordinating and communicating among the regulators and with the BHCs and (2) promoting transparency of the stress |
2,511 | test to the public. In addition, according to regulators, the process resulted in a methodology that yielded credible results and by design helped to assure that the BHCs would be sufficiently capitalized to weather a more adverse economic downturn. Robust coordination and communication are essential to programs like SCAP when bringing together regulatory staff from multiple agencies and disciplines to effectively analyze complex financial institutions and understand the interactions among multiple layers |
2,512 | of risk. Moreover, supervisory guidance emphasizes the importance of coordination and communication among regulators to both effectively assess banks and conduct coordinated supervisory reviews across a group of peer institutions, referred to as “horizontal examinations.” The regulators implemented each phase of SCAP in a coordinated interagency fashion. Also, while some disagreed, most regulators and market participants we interviewed were satisfied with the level of coordination and communication. They al |
2,513 | so thought that the SCAP process could serve as a model for future supervisory efforts. The regulators executed the SCAP process in three broad phases: In the first phase, the Analytical Group, comprising interagency economists and supervisors, generated two sets of economic conditions— a baseline scenario and a more adverse scenario with a worse-than- expected economic outcome—and then used these scenarios to aid in estimating industrywide indicative loan loss rates. To develop these scenarios, the Analyti |
2,514 | cal Group used three primary indicators of economic health: the U.S. GDP, housing prices in 10 key U.S. cities, and the annual average U.S. unemployment rate. The baseline scenario reflected the consensus view of the course for the economy as of February 2009, according to well-known professional economic forecasters. The Federal Reserve developed the more adverse scenario from the baseline scenario by taking into account the historical accuracy of the forecasts for unemployment and the GDP and the uncertai |
2,515 | nty of the economic outlook at that time by professional forecasters. The Federal Reserve also used regulators’ judgment about the appropriate severity of assumed additional stresses against which BHCs would be required to hold a capital buffer, given that the economy was already in a recession at the initiation of SCAP. In the second phase, several Supervisory Analytical and Advisory Teams— comprising interagency senior examiners, economists, accountants, lawyers, financial analysts, and other professional |
2,516 | s from the SCAP regulators—collected, verified, and analyzed each BHC’s estimates for losses, PPNR, and allowance for loan and lease losses (ALLL). The teams also collected additional data to evaluate the BHC’s estimates, and to allow supervisors to develop their own independent estimates of losses for loans, trading assets, counterparty credit risk, and securities and PPNR for each BHC. In the third phase, the Capital Assessment Group, comprising interagency staff, served as the informal decision-making bo |
2,517 | dy for SCAP. The Capital Assessment Group developed a framework for combing the Supervisory Analytical and Advisory Teams’ estimates with other independent supervisory estimates of loan losses and resources available to absorb these losses. They evaluated the estimates by comparing across BHCs and by aggregating over the 19 BHCs to check for consistency with the specified macroeconomic scenarios to calculate the amount, if any, of additional capital needed for each BHC to achieve the SCAP buffer target capi |
2,518 | tal ratios as of December 31, 2010, in the more adverse economic environment. Lastly, the Capital Assessment Group set two deadlines: (1) June 8, 2009, for BHCs requiring capital to develop and submit a capital plan to the Federal Reserve on how they would meet their SCAP capital shortfall and (2) November 9, 2009, for these BHCs to raise the required capital. A key component of this process was the involvement of multidisciplinary interagency teams that leveraged the skills and experiences of staff from di |
2,519 | fferent disciplines and agencies. The Federal Reserve, OCC, and FDIC had representatives on each SCAP team (the Analytical Group, Supervisory Analytical and Advisory Teams, and the Capital Assessment Group). For example, OCC officials said that they contributed to the development of quantitative models required for the implementation of SCAP and offered their own models for use in assessing the loss rates of certain portfolios. In addition, each of the SCAP regulators tapped expertise within their organizat |
2,520 | ion for specific disciplines, such as accounting, custodial banking, macroeconomics, commercial and industry loan loss modeling, and consumer risk modeling. According to the FDIC, the broad involvement of experts from across the agencies helped validate loss assumptions and also helped improve confidence in the results. Further, these officials noted that the SCAP process was enhanced because productive debate became a common event as team members from different regulatory agencies and disciplines brought t |
2,521 | heir own perspectives and ideas to the process. For example, some SCAP staff argued for a more moderate treatment of securities in BHCs’ available for sale portfolios, which would have been consistent with generally accepted accounting principles under a new change in accounting standards. They maintained that the modified accounting standard for declines in market value (and discounting the impact of liquidity premia) that had been implemented after the stress test was announced and before the numbers had |
2,522 | been finalized was in some ways more reflective of the realized credit loss expectations for the affected securities. After significant discussion, the regulators decided to allow for the accounting change in the baseline loss estimates, but not in the more adverse scenario estimates. They believed that under the more adverse scenario there was a heightened possibility of increased liquidity demands on banks and that many distressed securities would need to be liquidated at distressed levels. Consequently, |
2,523 | for securities found to be other than temporarily impaired in the more adverse scenario, they assumed the firm would have to realize all unrealized losses (i.e., write down the value of the security to market value as of year end 2008). Similarly, some staff argued against adopting other changes in accounting standards that were expected to impact BHCs’ balance sheets, including their capital adequacy. Primary among these was the inclusion of previously off-balance sheet items. As noted above, ultimately, t |
2,524 | he more conservative approach prevailed and the expected inclusion of these assets was addressed in SCAP. To facilitate coordination, the Federal Reserve instituted a voting system to resolve any contentious issues, but in practice differences among regulators were generally resolved through consensus. When SCAP regulators met, the Federal Reserve led the discussions and solicited input from other regulators. For example, officials from OCC and FDIC both told us that they felt that they were adequately invo |
2,525 | lved in tailoring the aggregate loss estimates to each BHC as part of the determination of each BHC’s SCAP capital requirement. SCAP regulators were also involved in drafting the design and results documents, which were publicly released by the Federal Reserve. Representatives from most of the BHCs were satisfied with the SCAP regulators’ coordination and communication. Many of the BHC officials stated that they were generally impressed with the onsite SCAP teams and said that these teams improved the BHCs’ |
2,526 | coordination and communication with the regulators. BHC officials said that they usually received answers to their questions in a timely manner, either during conference calls held three times a week, through the distribution of answers to frequently asked questions, or from onsite SCAP examiners. Collecting and aggregating data were among the most difficult and time- consuming tasks for BHCs, but most of them stated that the nature of the SCAP’s requests were clear. At the conclusion of SCAP, the regulato |
2,527 | rs presented the results to each of the institutions showing the final numbers that they planned to publish. The SCAP process included steps to promote transparency, such as the release of key program information to SCAP BHCs and the public. According to SCAP regulators, BHCs, and credit rating agency officials we interviewed, the release of the results provided specific information on the financial health and viability of the 19 largest BHCs regarding their ability to withstand additional losses during a t |
2,528 | ime of significant uncertainty. Many experts have said that the lack of transparency about potential losses from certain assets contributed significantly to the instability in financial markets during the current crisis. Such officials also stated that publicly releasing the methodology and results of the stress test helped strengthen market confidence. Further, many market observers have commented that the Federal Reserve’s unprecedented disclosure of sensitive supervisory information for each BHC helped E |
2,529 | uropean bank regulators decide to publicly release detailed results of their own stress tests in July 2010. Not all SCAP participants agreed that the SCAP process was fully transparent. For example, some participants questioned the transparency of certain assumptions used in developing the stress test. According to BHC officials and one regulator, the Federal Reserve could have shared more detailed information about SCAP loss assumptions and calculations with BHCs. According to several BHC officials, the Fe |
2,530 | deral Reserve did not fully explain the methodology for estimating losses but expected BHC officials to fully document and provide supporting data for all of their assumptions. Without knowing the details of the methodology, according to some BHC officials, they could not efficiently provide all relevant information to SCAP examiners. SCAP regulators aimed to ensure that SCAP sufficiently stressed BHCs’ risk exposures and potential PPNR under the more adverse scenario. To accomplish this, the regulators mad |
2,531 | e what they viewed to be conservative assumptions and decisions in the following areas. First, the regulators decided to stress only assets that were on the BHCs’ balance sheets as of December 31, 2008, (i.e., a static approach) without accounting for new business activity. According to BHC officials, new loans were thought to have generally been of better quality than legacy loans because BHCs had significantly tightened their underwriting standards since the onset of the financial crisis. As a result, BHC |
2,532 | s would have been less likely to charge- off these loans within the SCAP time period ending December 31, 2010, resulting in the potential for greater reported revenue estimates for the period. By excluding earnings from new business, risk-weighted assets were understated, charge-off rates were overstated, and projected capital levels were understated. Second, SCAP regulators generally did not allow the BHCs to cut expenses to address the anticipated drop in revenues under the more adverse scenario. However, |
2,533 | some BHC officials told us that they would likely cut expenses, including initiating rounds of layoffs, if the economy performed in accordance with the more adverse economic scenario, especially if they were not generating any new business. Federal Reserve officials noted that BHCs were given credit in the stress test for cost cuts made in the first quarter of 2009. Third, some BHCs were required to assume an increase in their ALLL as of the end of 2010, if necessary, to ensure adequate reserves relative t |
2,534 | o their year end 2010 portfolio. Some BHC officials believed that this requirement resulted in the BHCs having to raise additional capital because the required ALLL increases were subtracted from the revenue estimates in calculating the resources available to absorb losses. This meant that some BHCs judged to have insufficient year end 2010 reserve adequacy had to account for this shortcoming in the calculation of capital needed to meet the SCAP targeted capital requirements as of the end of 2010 while main |
2,535 | taining a sufficient ALLL for 2011 losses under the more adverse economic scenario. According to some BHCs, the size of the 2010 ALLL was severe given the extent of losses are already included in the 2009 and 2010 loss estimates and effectively stressed BHCs for a third year. Finally, according to many BHC officials and others, the calculations used to derive the loan loss rates and other assumptions to stress the BHCs were conservative (i.e., more severe). For example, the total loan loss rate estimated by |
2,536 | the SCAP regulators was 9.1 percent, which was greater than the historical 2-year loan loss rates at all commercial banks from 1921 until 2008, including the worst levels seen during the Great Depression (see figure 2). However, the macroeconomic assumptions of the more adverse scenario, which we will discuss later in the report, did not meet the definition of a depression. Specifically, a 25 percent unemployment rate coupled with economic contraction is indicative of a depression. In contrast, the more ad |
2,537 | verse scenario estimated approximately a 10 percent unemployment rate with some economic growth in late 2010. SCAP regulators also estimated ranges for loan loss rates within specific loan categories using the baseline and more adverse scenarios as guides. They used a variety of methods to tailor loan losses to each BHC, including an analysis of past BHC losses and quantitative models, and sought empirical support from BHCs regarding the risk level of their portfolios. However, some BHCs told us that the Fe |
2,538 | deral Reserve made substantial efforts to help ensure conformity with the indicative loan loss rates while incorporating BHC-specific information where possible and reliable. Table 1 compares the different indicative loan loss rate ranges under the more adverse scenario for each asset category with actual losses in 2009 for SCAP BHCs and the banking industry. Some BHCs stated that the resulting loan loss rates were indicative of an economy worse off than that represented by the more adverse macroeconomic as |
2,539 | sumptions, although they recognized the need for the more conservative approach. However, nearly all agreed that the loan loss rates were a more important indication of the stringency of SCAP than the assumptions. After the public release of the SCAP methodology in April 2009, many observers commented that the macroeconomic assumptions for a more adverse economic downturn were not severe enough given the economic conditions at that time. In defining a more adverse economic scenario, the SCAP regulators made |
2,540 | assumptions about the path of the economy using three broad macroeconomic indicators—changes in real GDP, the unemployment rate, and home prices—during the 2-year SCAP period ending December 2010. The actual performances of GDP and home prices have performed better than assumed under the more adverse scenario. However, the actual unemployment rate has more closely tracked the more adverse scenario (see figure 3). Further, as noted earlier, some regulatory and BHC officials have indicated that the loan loss |
2,541 | rates that the regulators subsequently developed were more severe than one would have expected under the macroeconomic assumptions. While our analysis of actual and SCAP estimated indicative loan losses (see table 1) is generally consistent with this view, these estimates were developed at a time of significant uncertainty about the direction of the economy and the financial markets, as well as an unprecedented deterioration in the U.S. housing markets. SCAP largely met its goals of increasing the level an |
2,542 | d quality of capital held by the 19 largest BHCs and, more broadly, of strengthening market confidence in the banking system. The stress test identified 10 of the 19 BHCs as needing to raise a total of about $75 billion in additional capital. The Federal Reserve encouraged the BHCs to raise common equity via private sources—for example, through new common equity issuances, conversion of existing preferred equity to common equity, and sales of businesses or portfolios of assets. Nine of the 10 BHCs were able |
2,543 | to raise the required SCAP amount of new common equity in the private markets by the November 9, 2009, deadline (see table 2). Some of these BHCs also raised capital internally from other sources. GMAC LLC (GMAC) was the only BHC that was not able to raise sufficient private capital by the November 9, 2009, deadline. On December 30, 2009, Treasury provided GMAC with a capital investment of $3.8 billion to help fulfill its SCAP capital buffer requirement, drawing funds from TARP’s Automotive Industry Financ |
2,544 | ing Program. A unique and additional element of the estimated losses for GMAC included the unknown impact of possible bankruptcy filings by General Motors Corporation (GM) and Chrysler LLC (Chrysler). Thus, a conservative estimate of GMAC’s capital buffer was developed in response to this possibility. The Federal Reserve, in consultation with Treasury, subsequently reduced GMAC’s SCAP required capital buffer by $1.8 billion—$5.6 billion to $3.8 billion—primarily to reflect the lower-than-estimated actual lo |
2,545 | sses from the bankruptcy proceedings of GM and Chrysler. GMAC was the only company to have its original capital buffer requirement reduced. Capital adequacy generally improved across all 19 SCAP BHCs during 2009. As shown in table 3, the largest gains were in tier 1 common capital, which increased by about 51 percent in the aggregate across the 19 BHCs, rising from $412.5 billion on December 31, 2008, to $621.9 billion by December 31, 2009. On an aggregate basis, the tier 1 common capital ratio at BHCs incr |
2,546 | eased from 5.3 percent to 8.3 percent of risk-weighted assets (compared with the SCAP threshold of 4 percent at the end of 2010). The tier 1 risk-based capital ratio also grew from 10.7 percent to 11.3 percent of risk-weighted assets (compared with the SCAP threshold of 6 percent at the end of 2010). While these ratios were helped to some extent by reductions in risk-weighted assets, which fell 4.3 percent from $7.815 trillion on December 31, 2008, to $7.481 trillion on December 31, 2009, the primary driver |
2,547 | of the increases was the increase in total tier 1 common capital. The quality of capital—measured as that portion of capital made up of tier 1 common equity—also increased across most of the BHCs in 2009. The tier 1 common capital ratio increased at 17 of the 19 BHCs between the end of 2008 and the end of 2009 (see table 4). Citigroup Inc. (Citigroup) and The Goldman Sachs Group, Inc. (Goldman Sachs) had the largest increases in tier 1 common capital ratios—747 and 450 basis points, respectively. However, |
2,548 | GMAC’s tier 1 common capital ratio declined by 155 basis points in this period to 4.85 percent. MetLife, Inc. was the only other BHC to see a drop in its tier 1 common capital ratio, which fell by 33 basis points to 8.17 percent and still more than double the 4 percent target. Based on the SCAP results document, the 2008 balances in the table include the impact of certain mergers and acquisitions, such as Bank of America Corporation’s (Bank of America) purchase of Merrill Lynch & Co. Inc. Further, the incre |
2,549 | ase in capital levels reflects the capital that was raised as a result of SCAP. As previously stated by interviewees, the unprecedented public release of the stress test results helped to restore investors’ confidence in the financial markets. Some officials from participating BHCs and credit rating agencies also viewed the BHCs’ ability to raise the capital required by the stress test as further evidence of SCAP’s success in increasing market confidence and reducing uncertainty. But some expressed concerns |
2,550 | that the timing of the announcement of SCAP on February 10, 2009—nearly 3 months before the results were released on May 7, 2009—may have intensified market uncertainty about the financial health of the BHCs. A broad set of market indicators also suggest that the public release of SCAP results may have helped reduce uncertainty in the financial markets and increased market confidence. For example, banks’ renewed ability to raise private capital reflects improvements in perceptions of the financial conditio |
2,551 | n of banks. Specifically, banks and thrifts raised significant amounts of common equity in 2008, totaling $56 billion. Banks and thrifts raised $63 billion in common equity in the second quarter of 2009 (see figure 4). The substantial increase in second quarter issuance of common equity occurred after the stress test results were released on May 7, 2009, and was dominated by several SCAP institutions. Similarly, stock market prices since the release of the stress test results in May 2009 through October 200 |
2,552 | 9 improved substantially in the overall banking sector and among the 18 public BHCs that participated in SCAP (see figure 5). The initial increase since May 2009 also suggests that SCAP may have helped bolster investor and public confidence. However, equity markets are generally volatile and react to a multitude of events. Credit default swap spreads, another measure of confidence in the banking sector, also improved. A credit default swap is an agreement in which a buyer pays a periodic fee to a seller in |
2,553 | exchange for protection from certain credit events such as bankruptcy, failure to pay debt obligations, or a restructuring related to a specific debt issuer or issues known as the reference entity. Therefore, the credit default swap spread, or market price, is a measure of the credit risk of the reference entity, with a higher spread indicating a greater amount of credit risk. When the markets’ perception of the reference entity’s credit risk deteriorates or improves, the spread generally will widen or tigh |
2,554 | ten, respectively. Following the SCAP results release in May 2009, the credit default swap spreads continued to see improvements (see figure 6). While many forces interact to influence investors’ actions, these declining spreads suggest that the market’s perception of the risk of banking sector defaults was falling. Further, the redemption of TARP investments by some banking institutions demonstrated that regulators believed these firms could continue to serve as a source of financial and managerial strengt |
2,555 | h, as well as fulfill their roles as intermediaries that facilitate lending, while both reducing reliance on government funding and maintaining adequate capital levels. This positive view of the regulators may also have helped increase market confidence in the banking system (see appendix II for details on the status of TARP investments in the institutions participating in SCAP). As of the end of 2009, while the SCAP BHCs generally had not experienced the level of losses that were estimated on a pro rata ba |
2,556 | sis under the stress test’s more adverse economic scenario, concerns remain that some banks could absorb potentially significant losses in certain asset categories that would erode capital levels. Collectively, the BHCs’ total loan losses of $141.2 billion were approximately 38 percent less than the GAO-calculated $229.4 billion in pro rata losses under the more adverse scenario for 2009 (see table 5). The BHCs also experienced significant gains in securities and trading and counterparty credit risk portfol |
2,557 | ios compared with estimated pro rata losses under SCAP. Total resources other than capital to absorb losses (resources) were relatively close to the pro rata amount, exceeding it by 4 percent. In tracking BHCs’ losses and resources against the SCAP estimates, we compared the actual results with those estimated under the more adverse scenario. We used the 2-year estimates of the more adverse scenario from the SCAP results and annualized those amounts by dividing them in half (the “straight line” method) to g |
2,558 | et pro rata loss estimates for 2009 because the SCAP regulators did not develop estimates on a quarterly or annual basis. A key limitation of this approach is that it assumes equal distribution of losses, revenues, expenses, and changes to reserves over time, although these items were unlikely to be distributed evenly over the 2-year period. Another important consideration is that actual results were not intended and should not be expected to align with the SCAP projections. Actual economic performance in 2 |
2,559 | 009 differed from the SCAP macroeconomic variable inputs, which were based on a scenario that was more adverse than was anticipated or than occurred, and other forces in the business and regulatory environment could have influenced the timing and level of losses. Appendix I contains additional details on our methodology, including our data sources and calculations, for tracking BHCs’ financial performance data. Although the 19 BHCs’ actual combined losses were less than the 2009 pro rata loss estimates for |
2,560 | the more adverse scenario, the loss rates varied significantly by individual BHCs. For example, most of the BHCs had consumer and commercial loan losses that were below the pro rata loss estimates, but three BHCs—GMAC, Citigroup, and SunTrust Banks Inc. (SunTrust)—exceeded these estimates in at least one portfolio (see figure 7). GMAC was the only one with 2009 loan losses on certain portfolios that exceeded SCAP’s full 2-year estimate. Specifically, GMAC exceeded the SCAP 2-year estimated losses in the fir |
2,561 | st-lien, second/junior lien, and commercial real estate portfolios and the 1-year pro rata losses in the “Other” portfolio; Citigroup exceeded the 1-year pro rata estimated losses in the commercial and industrial loan portfolio; and SunTrust exceeded the 1-year estimated losses in the first-lien and credit card portfolios. Appendix III provides detailed data on the individual performance of each of the BHCs. GMAC faced particular challenges in the first year of the assessment period and posed some risk to t |
2,562 | he federal government, a majority equity stakeholder. GMAC’s loan losses in its first-lien portfolio were $2.4 billion, compared with the $2 billion projected for the full 2-year period. In the second/junior lien portfolio, GMAC saw losses of $1.6 billion, compared with the $1.1 billion estimated losses for the 2 years. GMAC experienced losses of $710 million in its commercial real estate portfolio, compared with $600 million projected for the full 2-year period. Further, in its “Other” portfolio (which is |
2,563 | comprised of auto leases and consumer auto loans), GMAC’s losses were $2.1 billion, exceeding the 1-year pro rata $2 billion loss estimate. With a tier 1 common capital ratio of 4.85 percent— just more than the SCAP threshold of 4 percent—at the end of 2009, GMAC has a relatively small buffer in the face of potential losses. GMAC’s position should be placed in context, however, because it is relatively unique among the SCAP participants. It was the only nonpublicly traded participant, and the federal govern |
2,564 | ment owns a majority equity stake in the company as a result of capital investments made through the Automotive Industry Financing Program under TARP. Further, GMAC’s core business line—financing for automobiles—is dependent on the success of efforts to restructure, stabilize, and grow General Motors Company and Chrysler Group LLC. Finally, the Federal Reserve told us that because GMAC only recently became a BHC and had not previously been subject to banking regulations, it would take some time before GMAC |
2,565 | was fully assimilated into a regulated banking environment. To improve its future operating performance and better position itself to become a public company in the future, GMAC officials stated that the company posted large losses in the fourth quarter of 2009 as result of accelerating its recognition of lifetime losses on loans. In addition, the company has been restructuring its operations and recently sold off some nonperforming assets. However, the credit rating agencies we met with generally believed |
2,566 | that there could still be further losses at GMAC, although the agencies were less certain about the pace and level of those losses. Two of the agencies identified GMAC’s Residential Capital, LLC mortgage operation as the key source of potential continued losses. Given that market conditions have generally improved, the BHCs’ investments in securities and trading account assets performed considerably better in 2009 than had been estimated under the pro rata more adverse scenario. The SCAP assessment of the s |
2,567 | ecurities portfolio consisted of an evaluation for possible impairment of the portfolio’s assets, including Treasury securities, government agency securities, sovereign debt, and private sector securities. In the aggregate, the securities portfolio has experienced a gain of $3.5 billion in 2009, compared with a pro rata estimated loss of $17.6 billion under the stress test’s more adverse scenario. As figure 8 shows, 5 of the 19 BHCs recorded securities losses in 2009, 13 recorded gains, and 1 (Morgan Stanle |
2,568 | y) recorded no gain or loss. Losses were projected at 17 of the BHCs under the pro rata more adverse scenario, and SCAP regulators did not consider the remaining 2 BHCs (American Express Company and Morgan Stanley) to be applicable for this category. In the securities portfolio, The Bank of New York Mellon Corporation had losses greater than estimated under SCAP for the full 2-year period. The variances could be due to a number of factors, including the extent to which a BHC decides to deleverage, how their |
2,569 | positions react to changing market values, and other factors. To estimate trading and counterparty losses, SCAP regulators assumed that these investments would be subject to the change in value of a proportional level as experienced in the last half of 2008. The trading portfolio shows an even greater difference between the 1-year pro rata estimates and the actual performance—a gain of $56.9 billion in 2009 rather than the pro rata $49.7 billion estimated loss under the more adverse scenario (see table 5). |
2,570 | The stress test only calculated trading and counterparty credit loss estimates for the five BHCs with trading assets that exceeded $100 billion. All five had trading gains as opposed to losses, based on the publicly available data from the Y-9C. These gains were the result of a number of particular circumstances. First, the extreme spreads and risk premium resulting from the lack of liquidity during the financial crisis—especially in the second half of 2008—reversed in 2009, improving the pricing of many r |
2,571 | isky trading assets that remained on BHCs’ balance sheets. Because the trading portfolio is valued at fair value, it had been written down for the declines in value that occurred throughout 2008 and the first quarter of 2009 and saw significant gains when the market rebounded through the remainder of 2009. Second, the crisis led to the failure or absorption of several large investment banks, reducing the number of competitors and, according to our analysis of Thomson Reuters Datastream, increased market sha |
2,572 | re and pricing power for the remaining firms. Finally, the Federal Reserve’s low overnight bank lending rates (near 0 percent) have prevailed for a long period and have facilitated a favorable trading environment for BHCs. This enabled BHCs to fund longer-term, higher yielding assets in their trading portfolios with discounted wholesale funding (see figure 9). Potentially large losses in consumer and commercial loans continue to challenge SCAP BHCs, and addressing these challenges depends on a variety of fa |
2,573 | ctors, including, among other things, the effectiveness of federal efforts to reduce foreclosures in the residential mortgage market. The BHCs absorbed nearly $400 billion in losses in the 18 months ending December 31, 2008. As they continue to experience the effects of the recent financial crisis, estimating precisely how much more they could lose is difficult. In March 2010, officials from two credit rating agencies indicated that 50 percent or more of the losses the banking industry was expected to incur |
2,574 | during the current financial crisis could still be realized if the economy were to suffer further stresses. Data for the 19 BHCs show a rapid rise in the percentage of nonperforming loans over the course of 2009 (see figure 10). Specifically, total nonperforming loans grew from 1 percent in the first quarter of 2007 to 6.6 percent in the fourth quarter of 2009 for SCAP BHCs. In particular, increases in total nonperforming loans were driven by significant growth in nonperforming first-lien mortgages and com |
2,575 | mercial real estate loans. Standard & Poor’s Corporation noted that many nonperforming loans may ultimately have to be charged-off, exposing the BHCs to further potential losses. According to the credit rating agencies that we interviewed, federal housing policy to aid homeowners who are facing foreclosures, as well as time lags in the commercial real estate markets, will likely continue to affect the number of nonperforming loans for the remainder of the SCAP time frame (December 2010). The total amount of |
2,576 | resources other than capital to absorb losses (resources) has tracked the amount GAO prorated under the stress test’s more adverse scenario. Resources measure how much cushion the BHCs have to cover loans losses. As shown previously in table 5, the aggregate actual results through the end of 2009 for resources showed a total of $188.4 billion, or 4 percent more than GAO’s pro rata estimated $181.5 billion in the stress test’s more adverse scenario. Eleven of the 19 BHCs tracked greater than the pro rata es |
2,577 | timated amount in 2009, while the remaining 8 tracked less than the estimate (see figure 11). GMAC and MetLife, Inc. had negative resources in 2009, although only GMAC was projected to have negative resources over the full 2-year period. Our calculation considers increases in ALLL during 2009 to be a drain on resources in order to mirror the regulators’ calculation for the full 2-year projection. However, the ALLL may ultimately be used as a resource in 2010, causing available resources to be higher than th |
2,578 | ey currently appear in our tracking. PPNR is based on numerous factors, including interest income, trading revenues, and expenses. The future course of this resource will be affected by factors such as the performance of the general economy, the BHCs’ business strategies, and regulatory changes, including the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) and the Credit Card Accountability, Responsibility, and Disclosure Act of 2009. Such regulatory changes could impose a |
2,579 | dditional costs or reduce future profitability, either of which would impact future PPNR. The SCAP stress test provided lessons in a number of areas that can be incorporated in the bank supervision process and used to improve BHCs’ risk management practices. First, the transparency that was part of SCAP helped bolster market confidence, but the Federal Reserve has not yet developed a plan that incorporates transparency into the supervisory process. Second, the SCAP experience highlighted that BHCs’ stress t |
2,580 | ests in the past were not sufficiently comprehensive and we found that regulators’ oversight of these tests has been generally weak. Third, we identified opportunities to enhance both the process and data inputs for conducting stress testing in the future. Finally, SCAP demonstrated the importance of robust coordination and communication among the different regulators as an integral part of any effective supervisory process. By incorporating these lessons going forward, regulators will be able to enhance th |
2,581 | eir ability to efficiently and effectively oversee the risk- taking in the banking industry. As stated earlier and as agreed generally by market participants, the public release of the SCAP design and results helped restore confidence in the financial system during a period of severe turmoil. Some agency officials stated that their experience in implementing SCAP suggested that greater transparency would also be beneficial in the supervisory process. In recent statements, the chairman and a governor of the |
2,582 | Federal Reserve have both stated that, while protecting the confidentiality of firm-specific proprietary information is imperative, greater transparency about the methods and conclusions of future stress tests could benefit from greater scrutiny by the public. The Federal Reserve governor also noted that feedback from the public could help to improve the methodologies and assumptions used in the supervisory process. In addition, they noted that more transparency about the central bank’s activities overall w |
2,583 | ould ultimately enhance market discipline and that the Federal Reserve is looking at ways to enhance its disclosure policies. Consistent with the goal of greater transparency, we previously recommended that the Federal Reserve consider periodically disclosing to the public the aggregate performance of the 19 BHCs against the SCAP estimates for the 2-year forecast period. Subsequently, the chairman and a governor of the Federal Reserve have publicly disclosed 2009 aggregate information about the performance |
2,584 | of the 19 BHCs based on the Federal Reserve’s internal tracking. As the 2-year SCAP period comes to a close at the end of 2010, completing a final analysis that compares the performance of BHCs with the estimated performance under the more adverse economic scenario would be useful; however, at the time of the review, Federal Reserve officials told us that they have not decided whether to conduct and publicly release any type of analysis. Given that the chairman and a governor of the Federal Reserve have alr |
2,585 | eady publicly disclosed some aggregate BHC performance against the more adverse scenario for 2009, providing the 2-year results would provide the public with consistent and reliable information from the chief architect of the stress test that could be used to further establish the importance of understanding such tests and consider lessons learned about the rigor of the stress test estimates. Increasing transparency in the bank supervisory process is a more controversial issue to address. Supervisory offici |
2,586 | als from OCC (including the then Comptroller) and the Federal Reserve question the extent to which greater transparency would improve day-to-day bank supervision. And, some BHCs we interviewed also were against public disclosure of future stress tests results. They noted that SCAP was a one-time stress test conducted under unique circumstances. Specifically, during the financial crisis, Treasury had provided a capital backstop for BHCs that were unable to raise funds privately. They expressed concern that p |
2,587 | ublic disclosure of certain unfavorable information about individual banks in a normal market environment could cause depositors to withdraw funds en masse creating a “run” on the bank. In addition, banks that appear weaker than their peers could be placed at a competitive disadvantage and may encourage them to offer more aggressive rates and terms for new depositors, thereby increasing their riskiness and further affecting their financial stability. While these concerns are valid and deserve further consid |
2,588 | eration, they have to be weighed against the potential benefits of greater transparency about the financial health of financial institutions and the banking system in general to investors, creditors, and counterparties. The Dodd-Frank Act takes significant steps toward greater transparency. For example, the act requires the Federal Reserve to perform annual stress tests on systematically significant institutions and publicly release a summary of results. Also, the act requires each of the systematically sig |
2,589 | nificant institutions to publicly report the summary of internal stress tests semiannually. Given comments by its senior leadership, the Federal Reserve is willing to engage in a constructive dialogue about creating a plan for greater transparency that could benefit the entire financial sector. The other federal bank regulators—FDIC, OCC, and the Office of the Thrift Supervision—are also critical stakeholders in developing such a plan. While Federal Reserve officials have discussed possible options for incr |
2,590 | easing transparency, the regulators have yet to engage in a formal dialogue about these issues and have not formalized a plan for the public disclosure of regulatory banking information or developed a plan for integrating public disclosures into the ongoing supervisory process. Without a plan for reconciling these divergent views and for incorporating steps to enhance transparency into the supervisory process and practices, including the public disclosure of certain information, bank regulators may miss a s |
2,591 | ignificant opportunity to enhance market discipline by providing investors, creditors, and counterparties with information such as bank asset valuations. SCAP highlighted that the development and utilization of BHCs’ stress tests were limited. Further, BHC officials noted that they failed to adequately stress test for the effects of a severe economic downturn scenario and did not test on a firmwide basis or test frequently enough. We also found that the regulator’s oversight of these tests were weak, reinfo |
2,592 | rcing the need for more rigorous and firmwide stress testing, better risk governance processes by BHCs, and more vigorous oversight of BHCs’ stress tests by regulators. Going forward, as stress tests become a fundamental part of oversights of individual banks and the financial system, more specific guidance needs to be developed for examiners. BHCs and regulators stated that they are taking steps to address these shortcomings. Prior to SCAP, many BHCs generally performed stress tests on individual portfolio |
2,593 | s, such as commercial real estate or proprietary trading, rather than on a firmwide basis. SCAP led some institutions to look at their businesses in the aggregate to determine how losses would affect the holding company’s capital base rather than individual portfolios’ capital levels. As a result, some BHC officials indicated that they had begun making detailed assessments of their capital adequacy and risk management processes and are making improvements. Officials from one BHC noted that before SCAP their |
2,594 | financial and risk control teams had run separate stress tests, but had not communicate or coordinate with each other about their stress testing activities. Officials from another BHC noted that their senior management and board of directors were not actively involved in the oversight of the stress testing process. These officials said that since participating in SCAP, they have improved in these areas by institutionalizing the internal communication and coordination procedures between the financial risk a |
2,595 | nd control teams, and by increasing communication with senior management and board of directors about the need for active involvement in risk management oversight, respectively. These improvements can enhance the quality of the stress testing process. Moreover, officials of BHCs that were involved in ongoing bank mergers during the SCAP process credited SCAP with speeding up of the conversion process of the two institutions’ financial systems since the BHCs’ staff had to work together to be able to quickly |
2,596 | provide, among other things, the aggregate asset valuations and losses of the combined firm’s balance sheets to the regulators. BHC officials also stated that their stress tests would take a firmwide view, that is, taking into account all business units and risks within the holding company structure and would include updates of the economic inputs used to determine potential losses and capital needs in adverse scenarios. One BHC noted that it had developed several severe stress scenarios for liquidity becau |
2,597 | se the recent financial crisis had shown that liquidity could deteriorate more quickly than capital, endangering a company’s prospects for survival. This danger became evident in the failures of major financial institutions during the recent financial crisis— for example, IndyMac Bank, Lehman Brothers, and Bear Stearns. Officials from many SCAP BHCs and the Federal Reserve noted that internal bank stress test models generally did not use macroeconomic assumptions and loss rates inputs as conservative as tho |
2,598 | se used in the SCAP stress test. According to Federal Reserve officials, using the SCAP macroeconomic assumptions, most of the 19 BHCs that took part in SCAP initially determined that they would not need additional capital to weather the more adverse scenario. However, the SCAP test results subsequently showed that more than half of them (10 of 19) did need to raise capital to meet the SCAP capital buffer requirements. Some BHCs indicated that future stress tests would be more comprehensive than SCAP. BHCs |
2,599 | can tailor their stress test assumptions to match their specific business models, while SCAP generally used a one-size-fits-all assumptions approach. For example, some BHCs noted that they use macroeconomic inputs (such as disability claims, prolonged stagflation, or consumer confidence) that were not found in the SCAP stress test. Although the Federal Reserve has required BHCs to conduct stress tests since 1998, officials from several BHCs noted that their institutions had not conducted rigorous stress tes |
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