US Regulatory Stress Testing Implications for Large Banks

US Regulatory Stress Testing Implications for Large Banks Michael Jacobs, Ph.D., CFA Senior Manager Deloitte & Touche LLP Audit & Enterprise Risk Services Government, Risk and Regulatory Services November 2013 Pace University GARP Chapter Meeting

Agenda Executive Summary Regulatory Expectations & Timelines Implications for Banks Stress Testing Methodology and Processes Guidance and Key Considerations Industry Observations and Emerging Practices

Executive Summary Regulators setting higher standards on Banks's internal capabilities for assessing and stress testing capital adequacy as integral part of their overall risk management and capital planning framework Regulations Capital planning has become the key tool of US supervisors for monitoring and managing financial system and bank level soundness and stability Stress testing and CCAR has gone through multiple iterations and evolved significantly over time Recent rulemaking and guidance have set high expectation on the Bank s framework for stress testing and capital planning processes, system and governance Implications to Banks Large scale effort, which spans across the enterprise, with significant data sourcing, aggregation and processing needs to meet CCAR annual reporting and other business/regulatory needs Iterative validation and reconciliation efforts requiring intense manual intervention, to provide consistency across various regulatory requirements Integrating CCAR into the overall risk management and capital planning process Institutions need to significantly upgrade their capabilities to conduct periodic stress testing Road Ahead Establish effective governance mechanism, board approval, internal management review, accountability and transparency Implement systems, processes and controls to help provide the availability of consistent, highquality risk data that can easily be aggregated across their organization.

Evolving US banking regulatory landscape Stress testing and capital planning have become the key tool of US supervisors, especially Fed, for monitoring and managing financial system and bank level soundness and stability. These requirements have significantly evolved over time. 2013 2012 Basel III 1 5 CCAR / CapPR (Capital Plan) CCAR 2013 Guidance RESOLUTION PLANS 5 6 ENHANCED PRUDENTIAL STANDARDS 6 Basel II introduced Pillar II Supervisory 1 Guidance on Capital Adequacy, which I continued and enhanced in Basel III Requirements of Pillar II were detailed in the 2 ICAAP guidance and include in the use of stress testing 3 SCAP put forward the prescriptive requirements for 19 banks during 2009 which are in turn leveraged in later stress testing requirements 2011 2009 2007 CCAR ICCAP Basel II 3 2 1 Model Validation SCAP 4 3 4 Stress Testing Validation 3 CCAR formalizes regulatory expectations and provided fairly prescriptive guidance 4 Identifying, measuring, monitoring and managing model risk is a critical component of effective stress testing framework 5 The five stress testing principles established whereby banks should sensitivity analysis, reverse stress testing, scenario analysis 6 Enhanced prudential standards enshrines stress testing as regulatory tool for capital adequacy US Capital Regulations

Linkages amongst various regulations Given the overlapping nature of regulations, institutions need to take a broad and integrated view of regulatory capital Projected capital ratios are a key component of stress test results Capital plan approval is based on projected capital ratios Capital amount / ratios are a key input to resolution and contingency planning processes Stress Testing CCAR Living Wills Contingency plans Regulatory Capital Basel II / II.5 / III ICAAP Economic Capital Collins Amendment (floor) Enhanced Prudential Supervision Governance Early Remediation Counterparty limits Early remediation framework is based on capital ratio thresholds Oversight and governance of ICAAP is aligned with requirements under Enhanced Prudential Supervision Credit exposure calculation for counterparty limit is aligned with EAD calculation

CCAR Mission Forward-looking supervisory assessments to ensure determine that banking organizations are adequately capitalized From a micro prudential perspective, the CCAR provides a structured means for supervisors to assess not only whether banks hold enough capital, but also whether banks are able to rapidly and accurately determine their risk exposures, an essential element of effective risk management. The cross-firm nature of the stress tests also helps supervisors identify outliers--both in terms of results and practices-- that can provide a basis for further, more targeted reviews By Chairman Ben S Bernanke, April 8, 2013 6

CCAR Overview Supervisory assessment based on a combination of quantitative results from stress tests and qualitative assessment of the capital planning processes used by banks In February 2009, the Fed mandated 19 BHCs to participate in its Supervisory Capital Assessment Program (SCAP) that involved stress testing under two scenarios. Background This exercise contributed to gaining in-depth assessment of the financial system and provided lessons that were included in the Stress Test Rule of the 2010 Dodd-Frank Act Deficient BHCs were subjected to specific actions to raise capital, including through the U.S. Treasury s Capital Purchase Program or Capital Assistance Program Federal Reserve (Fed) Rulings In November 2010, the Fed issued guidelines requiring 19 large BHCs with total assets of $50B and above to participate in the CCAR 2011 process In December 2011, the Fed issued the Capital Plan rule formalizing the evaluation of capital adequacy on an annual basis CCAR 2011, has been followed with CCAR 2012 and CCAR 2013 in alignment with the Dodd Frank Act s requirements for annual capital adequacy assessment and stress testing requirements Ensure that institutions develop and demonstrate robust, forward-looking capital planning processes that account for their unique risks Objectives of CCAR Ensure that institutions establish sufficient capital to continue operations throughout times of economic and financial stress. Evaluate and approve/object to capital distribution plans proposed by institutions, based on the supervisory assessment of capital sufficiency and strength for each institution 7

Application of Rules and Timelines Multiple rules and/or additional guidance by Fed embeds stress testing as a cornerstone of the U.S. supervisory regime. Below is a summary of the capital planning and stress testing rules and timelines for their application by type of US banking institution. BHC Type Key Requirements Timing of Rules Application US BHC with global assets $500B or more (6 banks with large trading activities) Other Original SCAP Banks (12 banks with assets $100B or more) Other US BHCs $50B or more (12 banks) US BHCs $10B-$50B FBOs with $50B or more in US assets (excl. branches) FBOs with $10B-$50B in US assets (excl. branches) Submission of annual capital plans, with stress tests using supervisory Baseline, Adverse, and Severely Adverse and company scenarios (as at Sept 30, due Jan 5 each year) Required to run additional market risk shock scenarios Subject to supervisory stress tests on annual capital plans Submit FR Y-14 reports (including trading & counterparty schedules) Mid-year company-run stress tests (as at Mar 31, due July 5 each year) Publication of annual capital plans and mid -year stress tests within 90 days Same as above, except: o Not required to run additional market risk shock scenarios o Not required to submit detailed FR Y-14 trading & counterparty schedules Same as other original SCAPs Completion of annual stress tests using supervisory Baseline, Adverse, and severely Adverse scenarios (as at Sept 30, due Mar 31 each year) Publication of company run stress test results for Severely Adverse scenarios within 90 days of submission Required to establish US Intermediate Holding Company for US assets Same as US BHCs $50B or more Required to establish US Intermediate Holding Company for US assets Same as US BHCs $10B-$50B Already fully in effect, including publication of results Already fully in effect, including publication of results Were required to submit full 2013 capital plans Supervisory stress tests and publication of results starts from 2014 plans (fall 2013) Starts from fall 2013, including publication of results Starts from July 2015 Starts from July 2015

2013 Stress Test: Stress Test & Capital Plan Results Brief recap of CCAR 2013 Stress Testing Results and key highlights Quantitative: Minimum regulatory ratios Tier 1 Common ratio 5% Tier 1 Leverage ratio 3% or 4% Tier 1 risk-based Capital ratio 4% Total risk-based capital ratio 8% FRB Assessment Criteria Qualitative Considerations Robustness of BHC s capital adequacy assessment process, including corporate governance, controls and risk-measurement & management practices Reasonableness of assumptions and analyses underlying the BHC s capital plan Review of proposed capital distributions for sound practices Determine that no outstanding material, unresolved supervisory issues 2013 CCAR Assessment Results 2013 CCAR Observations 17 of 18 BHCs maintained capital above regulatory minimums in severely adverse scenarios Objections to capital plan of 2 banks: One on qualitative grounds (BB&T Corp) and the other on both quantitative & qualitative grounds (Ally Financials Inc.) Conditional non-objection to capital plan for 2 BHCs (JP Morgan Chase &Co. and The Goldman Sachs Groups, Inc.), owing to weaknesses in their capital plan or capital planning process 2 BHCs required to submit adjusted cap actions as they had at least one minimum post-stress capital ratio fall below regulatory minimum levels based on the original planned capital actions (American Express Company and Ally Financial Inc.) Minimum level of all four capital ratios significantly below the third-quarter 2012 value, with declines ranging between 2.7 and 5.0 percentage point. There is considerable variation across BHCs in the extent of the decline. Aggregate Tier 1 Common ratio fell 458 basis points post stress Aggregate Tier 1 leverage ratio fell 273 basis points post stress All 18 BHCs are on a path to successfully meet the Basel III requirements

Regulatory Expectations Regulatory expectations continue to evolve from initial SCAP to more prescriptive CCAR and SR 12-07 (i.e. BHC > $10 B) Institutions are expected to establish sound risk measurement and infrastructure supporting identification, measurement, assessment, and controls Translate risk measures into estimates of potential losses over a range of stressful scenarios and environments Use defined capital resources and estimation over the same range of stressful scenarios and environments used for estimating losses Capital planning and composition should be integrated with estimates of losses and capital adequacy Establish a comprehensive capital policy and robust capital planning practices for establishing capital goals Develop robust internal controls governing capital adequacy components, including policies and procedures; change control; model validation and independent review Effective Board and senior management oversight on Capital Adequacy Process (CAP), periodic reviews of risk infrastructure, methodologies

Supervisory Guidance Rules & Guidance Key areas of focus SR 99 18 U.S. Basel II Pillar II and ICAAP SR-09-04 SR 99-18 put forward the notion of assessing own internal capital adequacy, including the use of economic capital and stress testing Basel II introduced Pillar 2- Supervisory Guidance on Capital Adequacy Requirements of Pillar 2 introduced in Basel II were detailed in the ICAAP guidance and included the use of stress testing SR-09-04 linked dividend payment with elements of capital planning process such as identification of risks e.g. capital shortfall due to losses in a stress scenario SCAP SCAP put forward the prescriptive requirements for 19 banks during 2009, which are in turn leveraged in later stress requirements Model Validation (SR 11-7, OCC 2011-12) CCAR / CapPR for 2012 (published in 2011) Supervisory Guidance on Stress Testing (SR12-7), May 2012 CCAR/ CapPR 2013 guidance (published in 2012) FRY-14 Guidance Identifying, measuring, monitoring and managing model risk. This letter is guidance applicable to models used as part of stress testing framework CCAR formalized regulatory expectations and provided fairly prescriptive guidance associated with the role of stress testing and capital management, capital adequacy processes, and planning The five stress testing principles are broadly consistent with the principles outlined for CCAR/CapPR institutions. They are applicable to financial institutions that are $10 billion and above and also require banks to calculate sensitivities, complete reverse stress tests and complete scenario analysis The CCAR/ CapPR 2013 guidance (published in 2012) reinforces the 2012 guidance (published in 2011) and provides additional clarifications based on regulatory findings during the 2012 stress testing process on the principles and requirements previously outlined FRY-14 mandates reporting of quantitative projections of balance sheet, income, losses, and capital across a range of macroeconomic scenarios

Typical CCAR Processes Bank holding companies (BHCs) need continuous program to undertake Federal Reserve requirement towards submission of Comprehensive Capital Analysis and Review. BHCs need coordinated and cross functional effort, given below is generic functional view for understanding Risk Identification and Extraction Analysis, Review and Processing Reporting Schedules (for Submission) Product / Portfolios Information - Retail Exposures (Revolving/ Instalment) - Commercial Exposure - Other Risk Information (Ratings, Collateral, Segments) - Retail Risk Parameters (Internal and External) - Commercial Involved Party - Other Macro Variables (Per Economic Scenarios) Banks uses Fed. scenarios & develops proprietary macro variables Balance Forecasting - Balances are forecasted for 9 Quarters - Baseline is taken from Finance Information - Line Items / Segmentation for Loan Balances is defined Reconciliation - Y9C - Spreadsheets - Population, etc. Loss / Provisions (Projections) - Credit Loss Models are developed and validated per methodology - Portfolio specific Models are executed for Loss Projections ICCAP Documentation - Statement of Risk Appetite - Capital Adequacy - Capital Forecast - Liquidity Planning - Aggregation and Diversification - Model Validation Report - Governance FR Y 14 M (Retail Schedules) Credit Card Address Matching First Mortgage Home Equity FR Y 14 Q Schedules Basel III and DFA Retail Trading Wholesale Securities Operational Risk Pre Provision Net Revenue Regulatory Capital Instruments Historical Information - Delinquency - Payments - Charge off and Recovery Finance Information - IMPR Hierarchy - Balance Sheet Information Schedule Preparation - Loan and Summary Level Information - Calculate PPNR - Calculate Net Income - Capital Rations, RWA etc. Capital Planning Process - Planned Capital actions - Assumptions Review & Approve - Internal Reviews - Board Reviews - Challenge Process - Approval Process FR Y-14A Summary Macro Scenario Counterparty Credit Risk (CCR) Basel III and Dodd Frank Regulatory Capital Banks Capital Plan

Elements of Effective Stress-Test Modeling Frameworks Integration with Scenarios Specificity to the Bank Conservatism & Challenge - PPNR, Credit, Op Risk, and all models should integrate with the same inputs - Models should demonstrate ability to differentiate gains/losses well in Base and Adverse scenarios, showing sensitivity to different conditions - Chosen macro-factors should drive bank s losses/ppnr - Models and data inputs (e.g. housing prices) should reflect the footprint of the bank and the portfolio composition - Banks should demonstrate a forward-looking approach and justify that past data is still relevant - Idiosyncratic Scenario should reflect bank s specific risks - Banks should recognize model risk and the need to buffer their capital estimates - Banks should show a plan for continuous improvement for models and awareness of model limits - Banks should challenge and validate their models regularly Governance Right Team, Strong Process - Model monitoring & controls should be in place - Data quality checks and governance required - Clear integration with ICAAP process - Banks need to show ownership of models and results by the right people - Well-understood, clear process for stress-testing: Becomes part of Business As Usual

Sample Credit Loss Modeling Framework for CCAR Stress Testing Portfolio Segment Loan / Pool Data Modeling Approach Key Dependencies C&I - Major Industries - Oil & Gas - Agriculture - etc. Loan Level - Ratings - EAD / Balances - Vintage - NAIC Code Time Series Analysis - Predict quarterly changes in PD, LGD using footprint-specific state-level macro-factors (e.g. state-level Unemployment) and prior-period levels, for each industry segment - Valid PDs, LGDs, or charge-offs by Rating and by risk factor or industry segment - Rating history or reference data CRE - Construction - Income- Producing - Land Loan Level - Ratings / LTV / DSCR - EAD / Balances - Collateral Type (Retail, Industrial, etc) Time Series Analysis - Predict quarterly changes in LTV and DSCR using state-level macro-factors and vended property price data - Defaults trigger charge-offs Accurate LTVs and vintage Reference property price data histories by region and for CLTV Retail - Mortgage - HELOC - Credit Cards - Small Business - Other Portfolio Level - Historical charge-offs - Further segmentation - Vintage/maturity - Legacy acquisition Time Series and Static Regression - Predict Charge-offs as function of macro factors, deposits, prior-period balances, FICO, OLTV, Vintage, Status - Choice of method depends on data quality and history length Balance projections Charge-off reference data across credit cycle by risk factor Geography Loan Type Footprint Macroeconomic and External Data States - New York - Connecticut - New Jersey - etc. - National - State-level - MSA-level - Unemployment - GDP Growth - HPI - T-Bill Rates - etc. - Property Prices - Land Prices - BBB Bond Spread - Stock Price Volatility

Key Success Factors for Stress-Test Modeling Engagements Full ownership by the bank is the goal, with engagement in the business lines and process going forward Model validation, documentation, model use, and the bank team, must be prepared for reviews Driving ROI into Process, Concentration Management and Changing Risk Profile Knowledge and Tools Transfer Preparing for Challenges Alignment with Business What s Appropriate for the Bank Getting Results Together Do the proposed models fit your business? What loss and risk data do you have? Knowing the Bank s Story Using Intuitive Key Risk Drivers The Models and the narrative in the Capital Methodologies should be consistent and integrated Internal and external parties should see a model result and be able to understand how it was derived Modeling can be complex. Constant and ongoing communication with all interested parties is key (credit, liquidity, rate risk, market risk, operations risks)

Submission Timeline With consolidated assets between $10B and $50B Companies pull financial data to run stress test models. Overview of Annual Stress Testing Timeline FRB/OCC/FDIC publishes scenarios for upcoming annual cycle Companies complete stress tests and submit regulatory report to the Board Sept 30 Nov 15 Mar 31 Jun 15 Companies disclose summary of the results of the annual tests Key Differences: Delayed deadline to Mar 31 (against Jan 5), plus one additional year No requirements on mid-cycle stress test Less detailed disclosure of results for <$50 billion Significantly more limited reporting forms (to be devised) Management charged with responsibility of controls, oversight and documentation Slightly diminished Board responsibilities; however Board is still charged with reviewing and approving policies, procedures and stress test results Question on formal Capital Plan submission With consolidated assets greater than $50B Covered companies pull financial data to run stress test models. Companies to submit FR Y-14 data Covered companies submit regulatory report to board on stress tests Covered companies submit required regulatory report to the Board on mid-cycle stress test Sept 30 Nov 15 Jan 5 Mar 31 Jul 5 Sep 15-30 FRB publishes scenarios for upcoming annual cycle FRB communicates and publishes results of supervisory stress tests Companies disclose the summary results Companies make required public disclosures on their mid-cycle stress test

CCAR Reporting Monthly, Quarterly and Annual Primary Worksheets FR Y-14Q/M FR Y-14Q / M submissions required on quarterly or monthly basis (exposure data such as loan level details) Basel III & DFA Wholesale * Retail * Securities * Trading ** Operational Risk * Pre Provision Net Revenue Regulatory Capital Instruments FR Y-14A Income Statement Retail Counterparty Credit Risk Balance Sheet Wholesale Operational Risk FR Y-14A submissions required on an annual basis (Projected balances for scenarios) Capital Basel III & DFA AFS/HTM Securities Trading Pre Provision Net Revenue Regulatory Capital Instruments Supporting Documentation Model Risk Management Policy Documentation of Risk Measurement Practices Documentation of Internal Stress Testing methodology Documentation of assumptions and approaches Validation and Independent Review *Quarterly/Monthly reports subject to materiality threshold ** Quarterly/Monthly worksheets for trading required only for the 6 BHCs subject to trading shock in CCAR 2012 17

18 Typical Challenges Going forward, CCAR is likely to be a core planning element for Finance, Risk and IT functions in BHCs with a focus on achieving business integration and common data infrastructure Theme Methodology Data and IT Infrastructure Governance Implementation Challenges Ad-hoc execution of CCAR reporting and stress testing with limited focus on sustainment Credit risk modeling, loss modeling, finance and regulatory reporting (including Basel) are separately documented and not linked Alignment of CCAR requirements with a structured and flexible capital-planning framework Inconsistencies in business rules, definitions and assumptions related to key data fields such as PD and Lien information Multiple or duplicative data sourcing for key components such as Balance Forecasting, Loan loss modeling and credit risk modeling Significant effort for data sourcing, processing and manipulation to meet CCAR annual reporting and other business/regulatory needs Lack of a single platform to integrate the components of capital planning/ CCAR Lack of data availability (historical data, data pertaining to acquired businesses) Iterative validation and reconciliation effort requiring intense manual intervention Lack of active involvement by the Board and senior management in CCAR review and submission Capital planning/ CCAR is still not an integral part of strategy conversations and is thought of primarily as a regulatory exercise Identification and definition of roles and interactions specific to capital planning components

Emerging practices for effective stress testing Effective Stress test modeling frameworks include the following elements: Scenarios and integrated Infrastructure PPNR, Credit, Op Risk, and all models should integrate with the same inputs Chosen macro-factors should drive bank s losses/ppnr Creation of a single data platform to source, transform, aggregate and report data for CCAR and capital planning requirements Dedicated focus Governance Specificity to the Bank Other long term initiatives Identify key skill and experiences across business, risk, technology and finance required Banks need to show ownership of models and results by the right people Well-understood, clear process for stress-testing: becomes part of Business As Usual Model monitoring & controls should be in place based on functional awareness of model limits Adoption of a prioritization framework to allow focus on models/ issues that are critical in the capital planning process and communicate issues transparently Driving consistency in adoption of definitions, business rules and assumptions related to data, especially used for stress testing and projections Models and data inputs (e.g. housing prices) should reflect the footprint of the bank and the portfolio composition Idiosyncratic Scenario should reflect bank s specific risks Banks should demonstrate a forward-looking approach and justify that the past data pertaining to Bank is still relevant Integrating CCAR into longer term initiatives ( e.g. semi-annual stress testing, impact on ICAAP processes etc.) and aligning regulatory and internal definitions, and timelines Integrating CCAR processes into strategy, annual budgeting and planning cycle, performance reporting and internal audit Banks should challenge and validate their models regularly and show a plan for continuous improvement for models

Industry Observations Infrastructure supporting CCAR requirements at Banks are becoming more automated and sustainable, driven in part by regulatory feedback (MRA / MRIAs) Ad-hoc processes and manual adjustments persist, given rule ambiguity / interpretations and evolving regulatory expectations (i.e. Enhanced Prudential Guidelines, Basel III etc.) Differences exist in the underlying data and IT systems, processes and governance framework, with varying degrees of centralization (i.e. the extent to which guidance / specificity is provided centrally) o o o Scenario projections, capital actions, non-interest expense projections, policy and governance aspects are typically centralized Stress test loss projections, data and reconciliation are decentralized to LOB / LOB level credit risk teams Basel III RWA projections, loan balance and income projections may follow a mix of centralized and decentralized approaches Focus is primarily on BHC (enterprise) level planning o Increasing focus on standalone DI level planning (i.e. limit structure, risk appetite etc.) Identify and achieve easier action steps o Defining centralized governance frameworks (policies, committee charters) and use of centralized version control software Integrate CCAR process with longer term initiatives (internal budgeting, capital planning)

Q&A

Thanks Michael Jacobs, Jr., Ph.D., CFA Deloitte & Touche LLP Audit & Enterprise Risk Services / Government, Risk and Regulatory Services / Business Risk / Financial Services 1633 Broadway, 35 th Floor New York, N.Y.. 10281 Office: (212) 436-2956 Home: (212) 369-0025 Cellular: (917) 324-2098 e-mail: mikjacobs@deloitte.com SSRN Author Page: http://papers.ssrn.com/sol3/cf_dev/absbyauth.cfm?p er_id=97517 LinkedIn: http://www.linkedin.com/profile/view?id=17630774&tr k=tab_pro

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