Banking Crash Tests

During a crash test, cars are smashed head on into a wall at 35 miles-per-hour. Then, the side of the car is bashed in by a 1.5 ton barrier traveling 38.5 miles-per-hour. And, finally, the car is flipped over.

To pass the crash test passenger safety has to be a top priority for the car manufacturer. Only cars that can demonstrate solid safety features—by protecting the test dummies best during the simulated accident—get top safety ratings.

Similarly, stress testing is a central component of the new bank safety reforms put in place by the Dodd-Frank Act. This paper explains why and how banking regulators stress test banks, how the banks have performed, and what the implications are for our banking system.

A bank stress test—like a crash test—simulates a violent impact. Bank regulators test if a bank’s balance sheet is strong enough to withstand an economic crash. This year, the bank crash test simulated the impact of a massive recession worse than 2008, sky-rocketing unemployment rates, gut-churning losses in the stock market, along with other financial destruction.

Bank equity capital is like a car’s airbags. The role of equity capital is to absorb the impact of the losses that will occur during a severe financial collision. This year when the Federal Reserve put the largest 18 U.S. banks through their stress test, 16 earned passing crash-test grades.

Why Stress Test a Bank?

Bank stress tests estimate the impact of extreme negative economic conditions on a bank’s health. Stress tests are designed to answer the following questions: If—in the future—a devastating and unexpected economic crisis strikes how much money will a bank lose? And will the losses triggered by the crisis cause the bank to fail?

Bank failures are normally triggered when assets lose significant value. The value of bank assets—like mortgage loans, business loans, credit card loans, and commercial real estate loans—fall when consumers and businesses fail to keep up with their interest and principal payments.

Stress testing forces each big bank to contemplate how a future crisis will negatively impact the value of its specific asset holdings. When the economy slows and workers are laid off some will struggle to pay their credit card bills. Rising credit card defaults and delinquencies will cause a bank’s portfolio of credit card assets to shed value.

A bank with a sizeable portfolio of credit card assets has to ask, “How much value can we expect our credit card portfolio to lose if the economy stalls and unemployment spikes?”

Also, as part of the stress test, the Fed analyzes if a bank has quality processes and procedures in place to properly identify and measure the riskiness of its assets and account for its specific vulnerabilities.

The 2008 Banking Crash

The financial crisis was the economic equivalent of a 50-car pileup. The crisis triggered large losses to bank asset values, as mortgage and business loans defaulted. Lending slowed and by 2009, Gross Domestic Product (GDP) had shed 2.8%—the largest annual drop in GDP since 1946.¹ That’s a lot of stress for the economy and for banks.

After the failure of Lehman Brothers, confidence in the banking system had flat-lined. The Federal Reserve viewed rising levels of fear about the health of banks as a threat to economic recovery.

In 2009, with the economy in intensive care, the Fed introduced the first ever Fed-run bank stress tests—the Supervisory Capital Assessment Program (SCAP). This economic crash test was applied to the balance sheets of the19 biggest U.S. bank holding companies, those with over $100 billion in assets.^*

MetLife, which was among the original 19 banks tested in 2009, was not subject to stress testing in 2013 because the insurance company sold its affiliated bank.

The Fed’s hope was that the test results would soothe investor fears, and restore confidence. As a result of increased confidence companies would resume borrowing and banks would begin lending again. The economy would accelerate out of stall speed.

At the time, Federal Reserve Chairman Ben Bernanke described the tests as “an unprecedented, simultaneous supervisory review of the 19 largest bank holding companies in the United States."² Prior to SCAP, the banks had only performed self-stress tests. Amazingly, the Fed had never independently run tests in which they measured the ability of a bank to weather a future crisis.

The SCAP tests battered the banks and revealed that the assets of the19 largest banks would shed $600 billion during an economic meltdown.³ 10 of 19 banks were too weak to pass the test. The Fed required those 10 banks to increase capital to a safe level within 6 months by adding a total of $185 billion in capital to their balance sheets.⁴

In 2009, the Fed was attempting to provide a remedy for the fears in the market about big bank health. Therefore, the Fed decided to publicly disclose the test results in order to, in the words of Chairman Bernanke, provide “anxious investors with something they craved: credible information about prospective losses at banks."⁵

The Dodd-Frank Act built upon the foundation of these first tests and made stress testing an annual, set-in-statute requirement for banks.^*

The primary focus of this paper is on the largest U.S. banks—those with over $100 billion in assets. But, Dodd-Frank required banks with $10 billion or more in assets to be subject to some form of stress testing.

How Do You Stress Test a Bank?

For cars, a set of accidents are devised, and executed, and then the technicians come in to see how the test dummies fared. It is not much different for banks.

Dodd-Frank directs the Fed to design three new challenging scenarios to test the survival skills of bank holding companies over a stressful 9-quarter-period. In 2013, the latest test period started at the beginning of the 4th quarter of 2012 and ran through the end of 2014. The scenarios are: the mild “baseline,” the medium “adverse,” and the extra-strong “severely adverse.”

The severely adverse scenario is the test scenario that matters most. In the words of Chairman Bernanke, the scenario simulates “unlikely but plausible” conditions similar to the most severe post-World War II U.S. recessions, including the recession that began in 2008.⁶ In reality, a few of the stressful conditions developed by the Fed are actually worse than what occurred during the 2008 crisis.

To create havoc, the test manipulated 26 economic variables, 14 of which are U.S.-based measures of economic activity, such as GDP and the dollar exchange rate. The remaining 12 variables are measures of economic health in Europe and Asia. This year’s test included the assumption that the Eurozone, the UK, and Japan all fell into a recession and the developing nations of Asia experienced a significant economic slowdown.

The 2013 test was the toughest crash course for the 18 largest U.S. banks to date. The 18 banks tested were Ally Financial Inc., American Express Company, Bank of America Corporation, The Bank of New York Mellon, BB&T, Capital One Financial Corporation, Citigroup, Inc., Fifth Third Bancorp, The Goldman Sachs Group, Inc., JPMorgan Chase & Co., KeyCorp; Morgan Stanley, The PNC Financial Services Group, Inc., Regions Financial Corporation, State Street Corporation, SunTrust Banks, Inc., U.S. Bancorp, and Wells Fargo & Company.

The 2013 Fed Stress Test - “Severely Adverse” Economic Scenario

1. GDP: declines 3.9% on annual basis in 2013—the first full year in the test period. (In 2009, during the real Great Recession GDP declined by 2.8% on an annual basis.)⁷
2. The unemployment rate: increases from 8.1% at the start of the test, in the third quarter of 2012, to a peak of 12.1% in the second quarter of 2014. (From 2008 through 2009 the unemployment rate rose from 5.0% to a peak of 9.9%.)⁸
3. The Dow Jones Total Stock Market Index: drops 51%, tumbling from14,997 at the start of the test period to a low of 7,220 5 quarters later before rebounding. (In 2008, during the Great Recession, the index dropped 31.8%.)⁹
4. Housing prices: decline by 20.7% over the 9 quarter test period.¹⁰ (From the 4th quarter of 2007 through 2009, the Fed’s Home Price Index fell by 19.8%.)¹¹
5. Corporate borrowing costs: for BBB-rated companies, like Macy’s department stores, increase by 2.6% making it more expensive for companies to borrow. (During 2008 the average borrowing costs of BBB-rated companies increased by 2.9%.)¹²
6. Market volatility: The Chicago Board of Options Exchange’s stock market volatility index (known as the “VIX”) spikes to 79.4%. (In November 2008 the VIX reached its all-time-high of 80.8%.)¹³

Additionally, the 2013 test included a “global market shock” that applied solely to the 6 big banks with large securities trading portfolios (Bank of America, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, and Wells Fargo).

A bank’s trading portfolio contains securities that are required to be marked-to-market daily—the bank must value them at their market price each trading day.

The global market shock that these 6 banks planned for sent the prices of their trading assets sharply lower—triggering instantaneous losses to trading book assets. The intensity of the shock is similar to the market free fall that occurred after the fall of Lehman Brothers in the second half of 2008 when stock, derivative, and bond prices were all trading at prices that indicated a full-blown market panic.

Battering Bank Balance Sheets

Just as a brutal head-on collision causes damages to a car’s frame, a stress test scenario causes a bank’s balance sheet to deteriorate. Regulators continue to measure a bank’s structural safety and soundness—as indicated by balance sheet data—throughout the stress test.

The crash test dummies in this case are the assets, liabilities, and shareholder’s equity of the bank. They are the passengers on a bank’s balance sheet.

1. Assets: This is what a bank owns.¹⁴ This includes bank investments, and the funds that are owed to the bank, like mortgage and business loans. Bank assets represent the uses of a bank’s cash.
2. Liabilities: This is what a bank owes.¹⁵ This includes deposits and the funds that the bank has borrowed, like the total value of a bank’s bonds. Bank liabilities are the sources of a bank’s cash.
3. Shareholder’s Equity: This is the difference between a bank’s assets and a bank’s liabilities.¹⁶ It is the portion of a bank that shareholder’s own a claim to. Shareholder’s equity is mostly made up of the earnings the bank has retained—and not paid out to shareholder’s as dividends—in addition to the proceeds that a bank has received from selling its own shares.

The difference between what a bank owns (assets) and what a bank owes to others (liabilities) is a bank’s net worth (shareholder’s equity).

Bank stress tests evaluate if a bank can remain solvent throughout a crisis. A bank is solvent if its assets are worth more than its liabilities. In other words, a solvent bank is a bank with a positive net worth.

To put it in the perspective of a family, if the Joneses owe $300,000 on their mortgage and their house is also worth $300,000, the net worth, or home equity, is $0. This home adds nothing to the Jones family net worth because debt and assets are worth the same amount. But, if the home is valued at $400,000 then the Jones family has $100,000 in net worth even if they have no intention of selling their home for a long time.

In the case of a bank, if it holds $100 billion in assets and has $90 billion in liabilities, its net worth is $10 billion.

If the bank has issued 100 million shares of stock on the open market the book value of the share price will be $100 per share ($10 billion in equity divided by 100 million individual shares of stock).

A bank’s equity value, or net worth, will only retain a positive dollar value if a bank’s assets remain more valuable than its liabilities. And a bank’s stock price rises when investors think the bank is going to pile up profits in the future. If profits materialize, the value of a bank’s net worth increases. On the other hand, when bank assets rapidly drop in value the bank’s net worth falls too. As a result, their stock price plummets.

During the financial crisis, rapidly falling bank stock prices were a distress signal—bank asset values were falling sharply and eating into a bank’s net worth.

A large equity cushion is able to absorb larger asset losses, and a more severe crisis. That is why regulators judge bank safety by measuring a bank’s equity cushion versus bank assets—it is a good indicator for how severe an impact a bank can handle while still retaining a positive net worth.

How Does a Bank Pass the Test?

This equity cushion is of special interest for regulators when they stress test banks. Regulators focus on something called “Tier 1 Common Equity” when assessing a bank’s performance throughout the stress test. Tier 1 Common Equity is a term regulators use to describe the equity received from issuing stock to investors plus the bank’s retained earnings.

Retained earnings are the profits that a bank has chosen not to use to pay stock dividends or buy back shares with. For example, if a bank’s annual net income is $1.2 billion and it pays out $100 million in dividends, and uses $100 million to buy back shares, $1 billion is added to its retained earnings.

Tier 1 Capital vs. Tier 2 Capital

Tier 1 Common Equity is made up of funds invested by stockholders and retained earnings. Tier 2 Capital includes funds invested in the bank by unsecured bondholders—unsecured bond holders have no direct claim to specific bank assets—and other sources of unsecured financing. The purpose of requiring 5% in Tier 1 equity capital is to absorb losses first—prior to any losses being borne by Tier 2 unsecured debt holders. A large equity cushion can handle the first wave of losses and help a bank remain solvent during a crisis.

To pass the stress test, the Fed requires banks to maintain an amount of shareholder’s equity from selling shares of its stock plus retained earnings equal to at least 5% of a bank’s total risk-weighted-assets. Banks must maintain this ratio even as asset values are being demolished during the stress test.

Risk weights are based on an asset’s probability of default. U.S. Treasury bonds are considered “risk-free”—the market believes that they have a zero chance of default. Therefore, they have a 0% risk weight.

The 0% risk weight means that if a bank holds $10 billion worth of U.S. Treasury debt, it does not need to have any equity capital set aside in relation to its holdings of Treasuries.

Mortgage loans, corporate loans, and commercial real estate loans have a greater risk of default, and regulators require banks to calculate a larger amount of risk-weighted assets and a larger required airbag of common equity capital.

For example, a bank may own $100 billion in mortgage assets with a 50% risk-weight. The bank must calculate its required equity capital based on $50 billion in risk-weighted assets. And to pass the test, the bank must maintain at least $2.5 billion (5% of $50 billion) of Tier 1 Common Equity capital.

During the stress test, unemployment will soar, and housing prices decline sharply. If suddenly-unemployed homeowners become unable to pay their monthly mortgage payments the value of a bank’s mortgage assets will drop. A bank’s total asset losses—including mortgage asset losses—will be compared with its equity buffer. If the bank falls below the required 5% threshold, it has to bolster equity capital by issuing additional stock, reducing their dividend payments, or selling assets to raise cash.

Assessing How Banks Use Equity Capital under Stressful Conditions

During the financial crisis, banks were reluctant to reduce or halt dividends because of the negative signal it would send to their shareholders and the market. But reducing dividend payments keeps equity capital on the balance sheet—to help absorb any further losses to assets.

If—during an economically stressful time—a bank continues to pay a hefty dividend payment, it will be draining equity off its balance sheet as losses to asset values are eroding its equity capital. This could have disastrous consequences for the bank and cause its equity capital ratio to decline to below the 5% threshold.

This, in part, is why Dodd-Frank gave banking regulators two new tools to judge how banks use their equity capital throughout the stress test.

The first requires regulators to use a series of explicit assumptions about how banks will use their capital in the future.

For example, the test guidelines assume that dividend payments won’t increase or decrease from the past year’s level. This allows banking regulators to assess if a bank—under severe stress—can continue to pay cash dividends to shareholders at the same rate as in the past year, while maintaining equity of at least 5% of risk-weighted assets.

The second method—another new Dodd-Frank requirement— requires banks to provide regulators with a Capital Plan—an outline of their actual plans to pay dividends, buy back shares, and issue new shares of stock. This process is formally known as the Comprehensive Capital Assessment Review (CCAR).^*

This year, only banks with $100 billion or more in assets were subject to CCAR. But, in 2014, banks with over $50 billion in assets will be subject to CCAR. In 2013, these smaller banks were subject to a different stress test called the Capital Plan Review (CapPR).

Viewing a bank’s capital plan allows regulators to judge a bank’s planned dividend payments and share buy-back versus the asset losses that are triggered by the stressed scenario. This helps regulators answer the question: “Is this bank tough enough to survive a severe economic battering and make all of its planned dividend payments and share buy-backs while remaining healthy?”

CCAR forces banks to plan conservatively. As a report issued by the law firm Sullivan & Cromwell states, this worst-case-scenario planning “has the practical effect of limiting planned capital distributions to those that could be made in the severely adverse scenario."¹⁷

Forcing banks to plan their future dividend payments conservatively is important because in 2008, as crisis conditions emerged, many large banks continued to use cash that could have been kept on the balance sheet to instead maintain, or even increase, their dividend payments.¹⁸ It was their way of saying to investors, “don’t worry about us; we’re strong enough to increase our dividend.”

Judging the Quality of a Bank’s Capital Planning

The stress test is primarily a test of bank solvency. But to pass the test, a bank must also prove that it has quality processes in place to assess risk, judge its own specific vulnerabilities, and properly plan for a crisis scenario.

For example, each bank’s Capital Plan should describe the process the bank follows to make decisions on dividends and other distributions of capital. The Fed wants to see that the bank has rigorous decision making processes in place. An August 2013 Federal Reserve report urged banks to outline the “main factors and key metrics that influence the size, timing, and form of capital distributions” in their Capital Plans.¹⁹

The bank’s plan should describe how future economic stress could affect its planned dividends. The Fed urges banks to describe in detail the future economic “triggers” that would cause them to alter their planned dividend payments.²⁰

Essentially, what the Fed wants to see is if a bank’s Capital Plan outlines a thoughtful and credible process for judging the specific risks that the bank faces.

What are the Implications of Stress Tests?

The results of the 2013 test were encouraging. The18 biggest banks took everything a hypothetical crisis could dish out and 16 walked away with a solid safety rating. The banks proved that they are far better prepared to survive a collision than they were in 2009.

Of the 18 bank holding companies tested 17 proved they had sufficient equity capital to survive a crisis. Only Ally Financial failed to remain adequately capitalized during the stress test. The Fed “conditionally approved” the Capital Plans of J.P. Morgan and Goldman Sachs but required those 2 banks to resubmit their plans. BB&T’s Capital Plan was not approved—based on “qualitative” grounds—despite the bank’s passing capital ratios.

As a result of their passing grades, and with Fed approval, the 16 banks will be permitted to buy-back shares and increase their dividend payments.

If a bank fails the test, the Fed’s remedy is to prohibit the bank from increasing—or even paying—dividends until they prove that they can remain well-capitalized under duress. This possibility provides a strong incentive for banks to strengthen their balance sheet by adding capital.

Using the explicit Dodd-Frank assumptions for dividend payments, the average Tier 1 Common ratio for all 18 banks fell from 11.1% at end of the 3rd quarter of 2012 to a low of 7.4% during the stress test.²¹ At the end of the 9-quarter stress test period the ratio stood at 7.7%.²²

Under CCAR—where banks outline their actual plans to return capital to investors—the average ratio fell from 11.1% to a low of 6.6% under the stressful conditions.²³

The banks passed the crash tests because these18 banks have added nearly $400 billion in loss-absorbing, safety-increasing equity capital to their balance sheets since 2008.²⁴ The amount of big-bank Tier 1 Common equity capital has doubled, rising from 5.6% of risk-weighted assets at the end of 2008 to 11.3% at the end of 2012.²⁵

But positive stress test performance in the past is no guarantee of future success. The Fed’s recent report on capital planning reinforces their expectations for capital planning during future stress tests.

The Fed notes, “Even if current assessments of capital adequacy suggest that a BHC’s [Bank Holding Company] capital level is sufficient to withstand potential economic stress, robust capital planning helps ensure that this outcome will continue to hold true in the future."²⁶ So, clearly, the Fed wants banks to remain vigilant in assessing their risks.

Conclusion

The financial crisis destroyed bank balance sheets. At the end of 2008, the 18 biggest banks had just 5.6% of impact-absorbing Tier 1 Common equity capital as a percentage of their risk-weighted assets.

Currently, bank balance sheets are in the process of being repaired. Equity capital airbags have been increased by $400 billion since 2008.

At the end of 2012, the biggest 18 banks had equity equal to 11.3% of risk-weighted assets—double what they held in 2008. And, in the coming years, capital requirements are only going to get tougher.

The 2013 stress tests demonstrated that banks can execute their Capital Plan—under extreme economic duress—and when the dust settles have a post-stress average equity ratio of 6.6%. That is substantial progress.

Stress testing—and increased levels of equity capital—have effectively reduced the risk of a big bank failure. No matter how serene economic conditions appear, banks will still be required to prepare to survive a destructive economic scenario each year.