Recently, The Board of Governors of the Federal Reserve System  (Fed) completed another iteration of the DFAST (Dodd-Frank Act Stress Test) and CCAR (Comprehensive Capital Analysis and Review) stress tests, the results of which indicate that the 33 participating U.S. bank holding companies would be able to incur $526 billion in losses while being under a potential adversative scenario, according to a report from Kroll Bond Rating Agency  (KBRA).
While the tests may have shown that the largest bank holding companies are capitalized enough to withstand the Fed’s hypothetical severely adverse economic scenarios, KBRA believes investors should take note of the “harsh” verbiage contained in the results of the stress tests—and that liquidity rather than capital should be used to measure a bank’s ability to stand up during an economic shock.
The report states that total assets of this year’s tested banking institutions contain over 80 percent of domestic banking assets. Despite the fact that these firms would still likely incur significant losses particularly under the potential scenario, these firms have increased common equity capital by over $700 billion since 2009.
All participants passed the stress testing component of the Fed’s examination. For 2016, the Fed did not incorporate significant changes to its modeling framework, though it implemented additional improvements to the supervisory capital calculation in order to increase accuracy. In the report, KBRA states that in their opinion, both the quantitative and qualitative facets of the testing procedure are becoming more rigorous year after year. KBRA also stated that they believe the exercise is comparatively harsh on a number of regional banks. Although regulators continue to implement additional enhancements to the stress testing model each round, the output, in KBRA’s opinion, appears too onerous.
The global market shock scenario continues to be a key component of CCAR for major U.S. banks. For example, if Citigroup or JPMorgan Chase had actual tremendous trading losses, market confidence would likely denigrate, resulting in liquidity and funding becoming key issues.
According to previous reports done by KBRA, liquidity, not capital is the key indication of a bank’s ability to withstanding market stress, in their opinion. It is also their belief that a more dynamic global market shock stress test should be created to include key liquidity planning steps and contingent funding plans in the possibility of severe market related losses.
Although the U.S. banks collectively passed without much difficulty this year, particular subsidiaries of foreign banks were listed as having serious qualitative issues. In KBRA’s belief, the specific language from the Fed was particularly harsh. They believe that verbiage such as “material unresolved supervisory issues that critically undermine its capital planning process,” are harsher than necessary due to the fact that regulators usually do not make detailed public comments about institutions that still are open for business. This being said, KBRA shares that they feel investors should take note about the harshness of the Fed’s public criticism for these institutions.
Click here  to view KBRA’s full report.