The basics of CCAR stress testing
If you work in the world of U.S. banking and finance, or your goal is to do so, it’s important that you are up-to-date on at least the basics of mandated stress testing, particularly the annual Comprehensive Capital Analysis & Review (CCAR) stress test. This is a topic that could very easily come up during any job interview with a financial services firm.
Managed by the Federal Reserve, CCAR stress testing came about after the economic collapse of 2008. The Dodd-Frank Act was enacted, which requires both the Fed and all large bank holding companies (any banking organization with consolidated assets of $10 billion or more) to conduct and submit the results of the annual test - then disclose those results to the public.
“The CCAR stress test was the key factor in recruitment in 2014. Some banks failed the test, or realized they lacked the staff necessary to pass. Consequently, hiring CCAR specialists became an urgent requirement,” says Chris Stringer, manager of the banking & FS division at Robert Walters New York.
Stress tests are submitted according to macroeconomic scenarios provided by the Fed, and are used as protection to check for whether a bank’s system could theoretically handle a future economic shock. They test the bank’s ability to remain “well-capitalized,” with a minimum Tier 1 common equity ratio of 5 percent, even in a severely negative economic scenario. That hypothetical future scenario is supplied annually by the Fed to the banks so they can submit their responsive plans.
Under the rules of the CCAR exam, every mandated bank must submit a “capital action plan” for the following four quarters. The Fed then assesses that bank’s financial health and gives the bank a score. This score is not simply a “pass/fail”; banks are assessed in terms of exactly how strong they are. The Fed looks at whether or not banking organization have sufficient capital available to operate soundly even under extreme economic duress, and whether or not they have what the Fed calls “a robust, forward-looking capital-planning process that accounts for their unique risks.”
CCAR testing involves three main areas:
- Supervisory exercises
The Fed coordinates the testing of these areas and evaluates each banking organization on its capital adequacy, internal capital adequacy assessment processes, and individual plans.
Generally, after the CCAR and other stress test results are announced (usually in March), most of the banks held subject will follow up the test result announcements with their own announcements about plans to deploy excess capital through the next four quarters. Usually, this capital deployment comes in the form of dividend increases and share buybacks.
Chris Stringer continues: “Most of the big banks have been reducing their count of outstanding shares through buybacks over the past few years, which boosts earnings-per-share, supporting higher stock prices.”
The stress testing process is meant to reassure the banking public that, were the economy to melt down again, their dollars would be well protected. Therefore, it’s not just a legal mandate for banks, but an important PR strategy.
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