Whenthe Federal Reserve released the resultsfrom the most recent Dodd-Frank Act stress tests, the regulator's findings differed materially fromcompany-specific results. While the Fed's results were more dour thanbanks' on the all-important capital ratios, the central bank actually projectedsignificantly better revenue performance in a negative-rate environment.
An inabilityto reconcile the Fed's stress-test findings with their internal models has beena source of frustration for bankers, and this year's results proved no different.
"Ialways joke, it's a stress test and it's effective because we are stressed the wholetime," said U.S. BancorpCEO Richard Davis during the bank's second-quarter earnings call. He added that banks had not yet received lettersfrom the Fed detailing the results — not that those letters will have answers.
"Wewill never know exactly how the model works," Davis said.
The disconnectbetween banks and the Fed is, arguably, a feature of the stress tests. The Fed encouragesbanks to devise idiosyncratic stress tests specific to their case. Also, banks canapply an assumption — such as reduced lending in a recession — that the Fed doesnot apply to all banks. Further, the opacity ensures that banks cannot manipulatethe system. If a bank could reproduce the Fed's methodology, it could target thelowest possible capital ratio while still passing. With a black-box methodology,banks need to build in a buffer to ensure their capital ratios do not fall belowthe regulatory minimum.
Thisyear's results featured a very large gulf between the Fed's assumptions on revenueand the banks'. However, it was the Federal Reserve with the more optimistic outlook.
, the Federal Reserve estimatedrevenue for banks subject to the stress test would total $309.8 billion over thenine-quarter period, compared to the banks' aggregate estimate of $276.4 billion— a difference of $33.4 billion. In this year's stress test, the banks estimatedaggregate revenue of $272.3 billion over the nine-quarter period, compared to anestimate of $385.3 billion from the Fed — a difference of $113.0 billion.
"Whenyou talk about revenue, negative rates are a big question mark, so that could bea big reason for the divergence," said Joe Breeden, founder of Prescient Models,a company that offers banks consulting services on stress testing.
The Fedincluded negative ratesin this year's stress tests, a first for the exercise. The severely adverse scenarioincluded a drop in the three-month Treasury yield to negative-50 basis points, whereasthe low point in earlier stress tests was positive-10 basis points. It appears banks,weary from years of low rates, were more pessimistic about the revenue implicationsof negative rates.
The DFASTcapital ratios are perhaps the most important part of the process, as banks mustmeet minimum ratios or face regulatory sanction. The differences between Fed-runand company-run capital projections were relatively similar in this year's testwhen compared to last year's. Whereas the Fed was more optimistic on revenue, bankscontinued to be rosier on their capital ratios in the stressed environment.
Acrossthe 33 bank holding companies in this year's stress test, the average minimum commonequity Tier 1 ratio was 9.6%, compared to a Fed-run average of 8.9% — a differenceof 72 basis points. A year ago, when 31 banks reported results, the difference was74 basis points.
Breedensaid the stress tests remain on the same trajectory of improvement seen over thelast few years. As banks better their internal models, they can reduce the amountof "model risk" they build into assumptions. He said an emerging areaof concern — now that models are getting better and better — emanates from the roleof the validator. Banks employ various individuals to work on stress tests, includinga model developer, an auditor of the model and a validator of the model. In somecases, the validator will reject a useful model.
"It'sa process with a lot of checks but not a lot of balances," Breeden said. "Theperson builds the model, and then you put it to these lines of defense, but sometimesyou're defeating things that are actually pretty good."
To view the Federal Reserve-run 2015 Dodd-Frank Act stress-test results, click .
Click here to access a template with the Federal Reserve-run and the company-run 2015 Dodd-Frank Act stress-test results and supplemental data for the participating bank holding companies.
To view a video training session on CCAR and DFAST, click here.