This document introduces the stress test approach used by the Federal Reserve to regulate banks, comparing it to the previous Basel Accords approach. It discusses that the 2008 financial crisis showed the Basel Accords underestimated credit risk. In response, the Federal Reserve implemented the Dodd-Frank Act Stress Test (DFAST) and Comprehensive Capital Analysis Review (CCAR) to better evaluate capital adequacy. The stress test projects bank losses and capital levels under adverse economic scenarios, allowing regulators to ensure banks maintain sufficient capital buffers. The document argues stress testing is superior to the Basel Accords as it uses current economic conditions rather than historical data, and evaluates risks across the entire financial system rather than just individually.
This document discusses concepts of liquidity and liquidity risk within the financial system. It distinguishes between three types of liquidity: central bank liquidity, funding liquidity, and market liquidity. It analyzes linkages between these liquidity types in normal and turbulent times. In turbulent times, increased funding liquidity risk can contaminate market liquidity and necessitate central bank intervention. However, central bank liquidity alone cannot address the root causes of liquidity risk, which stem from information asymmetries and incomplete markets. Supervision and regulation are needed to minimize these issues and distinguish between solvent and insolvent institutions.
Basel III, albeit delayed, is set to change the banking landscape. More capital and greater liquidity will change the way banks do business in the future. More interestingly, Basel III could well lead a change in the financial services landscape globally. A "Shadow Banking Sector" is already a reality and Basel III opens up significant opportunities for capital rich emerging market banks.
This is a first in a series of presentations exploring Basel III, its impact on the global banking sector and most importantly possible response strategies banks could adopt to gain competitive advantage.
We measure how securitized assets, including mortgage-backed securities and other asset-backed securities, have shifted across financial institutions over this crisis and how the availability of financing has accommodated such shifts. Sectors dependent on repo financing – in particular, the hedge fund and broker-dealer sector – have reduced asset holdings, while the commercial banking sector, which has had access to more stable funding sources, has increased asset holdings. These findings are important to understand the role played by the government during the crisis as well as to understand the factors determining asset prices and liquidity during the crisis.
Zhiguo He (University of Chicago), In Gu Khang (Northwestern University) and Arvind Krishnamurthy (Northwestern University and NBER)
Basel III is an international regulatory framework that strengthens bank capital requirements in response to the financial crisis. It builds on Basel II and introduces new regulations on bank capital, liquidity, and risk. The three pillars from Basel II are maintained: minimum capital requirements, supervisory review, and market discipline. Major changes include higher and better quality capital, countercyclical capital buffers, leverage ratio restrictions, and liquidity standards like the Liquidity Coverage Ratio. Implementation began in 2013 and will be fully phased in by 2019. The goals are to strengthen financial stability and banking sector resilience to economic stress.
Dr. Charles Calomiris "An Incentive-Robust Program for Financial Reform"Nataly Nikitina
KSE Open Lecture with Dr. Charles Calomiris (Columbia University Graduate School of Business) on "An Incentive-Robust Program for Financial Reform" was held on April 12, 2011.
Investing for Physicians | 4th Quarter Market ReviewLFGmarketing
The document summarizes global market performance for the fourth quarter of 2012. International developed stocks posted strong returns of 5.93%, while emerging markets stocks returned 5.58%. US stocks saw more modest gains of 0.25%. The report provides an overview of asset class performance including international stocks, emerging markets stocks, real estate investment trusts and bonds. It also includes a timeline of major economic and political events that occurred during the quarter.
This document discusses concepts of liquidity and liquidity risk within the financial system. It distinguishes between three types of liquidity: central bank liquidity, funding liquidity, and market liquidity. It analyzes linkages between these liquidity types in normal and turbulent times. In turbulent times, increased funding liquidity risk can contaminate market liquidity and necessitate central bank intervention. However, central bank liquidity alone cannot address the root causes of liquidity risk, which stem from information asymmetries and incomplete markets. Supervision and regulation are needed to minimize these issues and distinguish between solvent and insolvent institutions.
Basel III, albeit delayed, is set to change the banking landscape. More capital and greater liquidity will change the way banks do business in the future. More interestingly, Basel III could well lead a change in the financial services landscape globally. A "Shadow Banking Sector" is already a reality and Basel III opens up significant opportunities for capital rich emerging market banks.
This is a first in a series of presentations exploring Basel III, its impact on the global banking sector and most importantly possible response strategies banks could adopt to gain competitive advantage.
We measure how securitized assets, including mortgage-backed securities and other asset-backed securities, have shifted across financial institutions over this crisis and how the availability of financing has accommodated such shifts. Sectors dependent on repo financing – in particular, the hedge fund and broker-dealer sector – have reduced asset holdings, while the commercial banking sector, which has had access to more stable funding sources, has increased asset holdings. These findings are important to understand the role played by the government during the crisis as well as to understand the factors determining asset prices and liquidity during the crisis.
Zhiguo He (University of Chicago), In Gu Khang (Northwestern University) and Arvind Krishnamurthy (Northwestern University and NBER)
Basel III is an international regulatory framework that strengthens bank capital requirements in response to the financial crisis. It builds on Basel II and introduces new regulations on bank capital, liquidity, and risk. The three pillars from Basel II are maintained: minimum capital requirements, supervisory review, and market discipline. Major changes include higher and better quality capital, countercyclical capital buffers, leverage ratio restrictions, and liquidity standards like the Liquidity Coverage Ratio. Implementation began in 2013 and will be fully phased in by 2019. The goals are to strengthen financial stability and banking sector resilience to economic stress.
Dr. Charles Calomiris "An Incentive-Robust Program for Financial Reform"Nataly Nikitina
KSE Open Lecture with Dr. Charles Calomiris (Columbia University Graduate School of Business) on "An Incentive-Robust Program for Financial Reform" was held on April 12, 2011.
Investing for Physicians | 4th Quarter Market ReviewLFGmarketing
The document summarizes global market performance for the fourth quarter of 2012. International developed stocks posted strong returns of 5.93%, while emerging markets stocks returned 5.58%. US stocks saw more modest gains of 0.25%. The report provides an overview of asset class performance including international stocks, emerging markets stocks, real estate investment trusts and bonds. It also includes a timeline of major economic and political events that occurred during the quarter.
1) As the U.S. pays down the public debt, it raises important issues regarding benchmarks for risk-free assets, how the Federal Reserve conducts monetary policy, and what kinds of assets the government might accumulate.
2) The swap market has taken on some of the benchmark role of Treasuries, but it does not fully substitute as Treasuries are not subject to default risk. The Federal Reserve may need to use different tools for open market operations as Treasuries decline.
3) Accumulating assets raises questions about what types of investments the government should hold, like state/local bonds or private fixed income, and how to manage the investments independently and avoid conflicts of interest.
1) Global stock markets posted positive returns in Q4 2012, led by developed international markets, global real estate, and emerging markets.
2) US stocks returned 0.25% for the quarter, underperforming other major global indices.
3) Bond markets were mostly flat, with the US bond market returning 0.22% for the quarter.
- Food prices have risen significantly since 2001 as supplies have fallen, with the most dramatic changes occurring between 2005-2008. Continued increases are expected due to rising demand from developing countries.
- Commodity investments by funds have increased substantially, which some argue has contributed to higher prices. However, studies have found little evidence that speculation has played a material role in price rises. Price increases have also occurred for commodities not traded on futures markets, indicating fundamentals are a primary driver. While correlations exist, position changes do not clearly precede price changes, suggesting speculation reflects rather than causes price movements.
This document summarizes a presentation on core deposit modeling best practices. It discusses topics like rate sensitivities in a rising rate environment, valuation of core deposits, sensitivity analysis, liquidity concerns, core deposit studies and behavioral inputs. Key points covered include using historical data to model rate sensitivities, the GAAP definition of valuing core deposits as the present value of average balances discounted by alternative funding costs, and the importance of sensitivity analysis and considering different scenarios in modeling.
This document summarizes a research paper that studies the effects of financial structure and financial development on banking fragility using panel data regression analysis. The study finds that banking stability is enhanced in market-based financial systems, but that financial development can reduce stability. However, the fragility-enhancing effect of financial development can only be seen when accounting for financial structure. Thus, the research concludes that financial structure and development jointly influence banking fragility. The document provides context on the motivation and methodology of the research paper.
EPS Liquidity Risk Management Implementation for FBOs-client presentationsarojkdas
The document discusses the liquidity risk management requirements under the Enhanced Prudential Standards (EPS) for foreign banking organizations operating in the US. It notes that the EPS placed significant emphasis on liquidity risk management and clarified roles for risk committees and CROs. It also reinforced stress testing, contingency funding plans, limits monitoring, and buffer requirements. Transitioning to comply will require enhancements to governance frameworks, cash flow projections, stress testing, and internal controls. Meeting the requirements will impact branches, BHCs, and intermediate holding companies.
The document summarizes Basel I and Basel II capital accords. Basel I, established in 1988, was the first international agreement that defined capital requirements for banks. It had several shortcomings that led to the development of Basel II in 2004, which improved risk sensitivity and introduced three pillars for regulatory capital, supervisory review, and market discipline. The purpose of Basel II was to establish a more sophisticated framework for ensuring banks have sufficient capital to cover their risks.
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This presentation is the one stop point to learn about Basel Norms in the Banking
This is the most comprehensive presentation on Risk Management in Banks and Basel Norms. It presents in details the evolution of Basel Norms right form Pre Basel area till implementation of Basel III in 2019 along with factors and reason for shifting of Basel I to II and finally to III.
Links to Video's in the presentation
Risk Management in Banks
https://www.youtube.com/watch?v=fZ5_V4RW5pE
Tier 1 Capital
http://www.investopedia.com/terms/t/tier1capital.asp
Tier 2 Capital
http://www.investopedia.com/terms/t/tier2capital.asp
Basel I
http://www.investopedia.com/terms/b/basel_i.asp
Capital Adequacy Ratio
http://www.investopedia.com/terms/c/capitaladequacyratio.asp
Basel II
http://www.investopedia.com/video/play/what-basel-ii/?header_alt=c
Basel III
http://www.investopedia.com/terms/b/basell-iii.asp
RBI Governor - Raghuram G Rajan on the importance if Basel III regulations
https://youtu.be/EN27ZRe_28A
The Basel Committee on Banking Supervision was established in 1974 in response to the Herstatt Bank failure and worked to establish common global banking standards and regulations. It has developed 3 accords - Basel I in 1988 focused on credit risk, Basel II in 2004 expanded coverage of risks, and Basel III from 2010 onward strengthened bank capital requirements and introduced new regulatory requirements on bank liquidity and leverage. The Basel accords aim to create a stable and consistent global framework for banking supervision and regulation.
Basel III is a global regulatory standard that aims to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and leverage. It was developed in response to deficiencies in previous regulations that contributed to the global financial crisis. The goals of Basel III include improving the banking sector's ability to absorb shocks from financial and economic stress, reducing risks, and strengthening transparency. Key changes under Basel III include higher and better quality capital buffers, introduction of leverage ratio, liquidity coverage ratio, net stable funding ratio, and capital surcharges for systemically important banks.
The Basel Accords are a series of banking regulations established by the Basel Committee on Banking Supervision. The document discusses the history and objectives of the Basel Accords. It explains that the Basel Committee was established in 1974 to improve banking supervision globally and set minimum capital requirements for banks. The Basel I Accord established the first capital requirements in 1988. Subsequent accords like Basel II and III enhanced regulations around capital adequacy ratios, risk management, disclosure, and liquidity to promote global financial stability.
Basel Accords - Basel I, II, and III Advantages, limitations and contrastSyed Ashraf Ali
The Basel Accords is referred to the banking supervision Accords (recommendations on banking regulations). Basel I, Basel II and Basel III was issued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel accords as the BCBS maintains its secretariat at the Bank for
International Settlements in Basel, Switzerland and the committee normally meets there. The Basel Accords is a set of
recommendations for regulations in the banking industry.
Basel III is a global regulatory standard that aims to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and leverage. It was implemented in response to deficiencies in the previous Basel II framework that were exposed by the global financial crisis. The goals of Basel III include improving the banking sector's ability to absorb shocks, reducing systemic risk, and increasing transparency. It establishes stricter capital standards, introduces capital buffers, and imposes new liquidity measures including the liquidity coverage ratio and net stable funding ratio.
This document discusses the major components of stress testing processes required by regulators. It covers economic scenarios, cash flow models, new business plans, capital consumption models, income/expense models, and capital ratios. Accurately modeling cash flows is challenging, as separate risk functions make aggregation difficult. Regulators expect banks to use competing risk models to simultaneously consider multiple risk factors. Data and model limitations remain issues for banks to address.
Basel II is an international banking accord that establishes capital requirements for banks. It aims to create an international standard for how much capital banks need to put aside to guard against financial and operational risks. Basel II includes three pillars: minimum capital requirements, supervisory review, and market discipline. It addresses deficiencies in Basel I by incorporating additional risk categories like credit and operational risk. Implementing Basel II poses challenges for Indian banks like increased capital requirements, the need for risk management expertise and technology investments. However, gradual implementation could help Indian banks migrate smoothly to the new framework.
Basel 3 is an update to the Basel Accords that aims to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and leverage. Key changes include tighter definitions of Tier 1 capital, a leverage ratio, countercyclical capital buffers, and new liquidity standards. The goals are to promote a more resilient banking system and reduce risk of financial crises. Basel 3 also seeks to address procyclicality concerns by promoting capital conservation and countercyclical buffers.
Basel II is an international standard that aims to strengthen the regulation, supervision and risk management within the banking sector. It improves upon Basel I by making capital requirements more risk sensitive and aligning regulatory capital more closely with underlying bank risks. Basel II consists of three pillars that cover minimum capital requirements, supervisory review, and market discipline. Implementation of Basel II varies across countries and regulators but aims to modernize capital adequacy standards to be more comprehensive and risk sensitive.
The document discusses the evolution of the Basel Accords from 1988 to the present. It highlights that:
1) Basel I, adopted in 1988, aimed to strengthen bank stability and create equal competition. However, it only considered credit risk and encouraged regulatory arbitrage.
2) Basel II, introduced in 2004, aimed to make capital requirements more risk-sensitive by incorporating banks' internal risk management. It included three pillars for minimum capital, supervisory review, and market discipline.
3) While Basel III, finalized in 2010 after the financial crisis, aims to mitigate past damage, the results of its stricter capital standards are still to be seen as countries implement its guidelines.
Impact of Basel III on business of Indian Banks.pptxssuserffce38
This document provides an overview of the Basel III accord. It discusses the limitations of Basel II in addressing the global financial crisis, including its lack of emphasis on liquidity and leverage. Basel III was created in response to strengthen regulations. Its main objectives are to promote a more resilient banking sector and improve the ability to withstand financial stress. The key building blocks of Basel III include reforms to capital requirements, introducing stricter criteria for capital instruments and higher minimum thresholds. It also includes introducing a leverage ratio, capital conservation buffer, and countercyclical buffer to limit procyclicality.
The document discusses the Basel II Accords, which establish international standards for banking regulations and capital requirements. Basel II aims to make capital requirements more risk-sensitive by measuring credit, operational, and market risks. It introduces a three pillar framework: Pillar 1 sets minimum capital standards; Pillar 2 establishes supervisory review; and Pillar 3 promotes market discipline through disclosure. Implementation of Basel II varies by country and bank sophistication in risk measurement. The overall goal is a safer, more stable global banking system.
1) As the U.S. pays down the public debt, it raises important issues regarding benchmarks for risk-free assets, how the Federal Reserve conducts monetary policy, and what kinds of assets the government might accumulate.
2) The swap market has taken on some of the benchmark role of Treasuries, but it does not fully substitute as Treasuries are not subject to default risk. The Federal Reserve may need to use different tools for open market operations as Treasuries decline.
3) Accumulating assets raises questions about what types of investments the government should hold, like state/local bonds or private fixed income, and how to manage the investments independently and avoid conflicts of interest.
1) Global stock markets posted positive returns in Q4 2012, led by developed international markets, global real estate, and emerging markets.
2) US stocks returned 0.25% for the quarter, underperforming other major global indices.
3) Bond markets were mostly flat, with the US bond market returning 0.22% for the quarter.
- Food prices have risen significantly since 2001 as supplies have fallen, with the most dramatic changes occurring between 2005-2008. Continued increases are expected due to rising demand from developing countries.
- Commodity investments by funds have increased substantially, which some argue has contributed to higher prices. However, studies have found little evidence that speculation has played a material role in price rises. Price increases have also occurred for commodities not traded on futures markets, indicating fundamentals are a primary driver. While correlations exist, position changes do not clearly precede price changes, suggesting speculation reflects rather than causes price movements.
This document summarizes a presentation on core deposit modeling best practices. It discusses topics like rate sensitivities in a rising rate environment, valuation of core deposits, sensitivity analysis, liquidity concerns, core deposit studies and behavioral inputs. Key points covered include using historical data to model rate sensitivities, the GAAP definition of valuing core deposits as the present value of average balances discounted by alternative funding costs, and the importance of sensitivity analysis and considering different scenarios in modeling.
This document summarizes a research paper that studies the effects of financial structure and financial development on banking fragility using panel data regression analysis. The study finds that banking stability is enhanced in market-based financial systems, but that financial development can reduce stability. However, the fragility-enhancing effect of financial development can only be seen when accounting for financial structure. Thus, the research concludes that financial structure and development jointly influence banking fragility. The document provides context on the motivation and methodology of the research paper.
EPS Liquidity Risk Management Implementation for FBOs-client presentationsarojkdas
The document discusses the liquidity risk management requirements under the Enhanced Prudential Standards (EPS) for foreign banking organizations operating in the US. It notes that the EPS placed significant emphasis on liquidity risk management and clarified roles for risk committees and CROs. It also reinforced stress testing, contingency funding plans, limits monitoring, and buffer requirements. Transitioning to comply will require enhancements to governance frameworks, cash flow projections, stress testing, and internal controls. Meeting the requirements will impact branches, BHCs, and intermediate holding companies.
The document summarizes Basel I and Basel II capital accords. Basel I, established in 1988, was the first international agreement that defined capital requirements for banks. It had several shortcomings that led to the development of Basel II in 2004, which improved risk sensitivity and introduced three pillars for regulatory capital, supervisory review, and market discipline. The purpose of Basel II was to establish a more sophisticated framework for ensuring banks have sufficient capital to cover their risks.
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This presentation is the one stop point to learn about Basel Norms in the Banking
This is the most comprehensive presentation on Risk Management in Banks and Basel Norms. It presents in details the evolution of Basel Norms right form Pre Basel area till implementation of Basel III in 2019 along with factors and reason for shifting of Basel I to II and finally to III.
Links to Video's in the presentation
Risk Management in Banks
https://www.youtube.com/watch?v=fZ5_V4RW5pE
Tier 1 Capital
http://www.investopedia.com/terms/t/tier1capital.asp
Tier 2 Capital
http://www.investopedia.com/terms/t/tier2capital.asp
Basel I
http://www.investopedia.com/terms/b/basel_i.asp
Capital Adequacy Ratio
http://www.investopedia.com/terms/c/capitaladequacyratio.asp
Basel II
http://www.investopedia.com/video/play/what-basel-ii/?header_alt=c
Basel III
http://www.investopedia.com/terms/b/basell-iii.asp
RBI Governor - Raghuram G Rajan on the importance if Basel III regulations
https://youtu.be/EN27ZRe_28A
The Basel Committee on Banking Supervision was established in 1974 in response to the Herstatt Bank failure and worked to establish common global banking standards and regulations. It has developed 3 accords - Basel I in 1988 focused on credit risk, Basel II in 2004 expanded coverage of risks, and Basel III from 2010 onward strengthened bank capital requirements and introduced new regulatory requirements on bank liquidity and leverage. The Basel accords aim to create a stable and consistent global framework for banking supervision and regulation.
Basel III is a global regulatory standard that aims to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and leverage. It was developed in response to deficiencies in previous regulations that contributed to the global financial crisis. The goals of Basel III include improving the banking sector's ability to absorb shocks from financial and economic stress, reducing risks, and strengthening transparency. Key changes under Basel III include higher and better quality capital buffers, introduction of leverage ratio, liquidity coverage ratio, net stable funding ratio, and capital surcharges for systemically important banks.
The Basel Accords are a series of banking regulations established by the Basel Committee on Banking Supervision. The document discusses the history and objectives of the Basel Accords. It explains that the Basel Committee was established in 1974 to improve banking supervision globally and set minimum capital requirements for banks. The Basel I Accord established the first capital requirements in 1988. Subsequent accords like Basel II and III enhanced regulations around capital adequacy ratios, risk management, disclosure, and liquidity to promote global financial stability.
Basel Accords - Basel I, II, and III Advantages, limitations and contrastSyed Ashraf Ali
The Basel Accords is referred to the banking supervision Accords (recommendations on banking regulations). Basel I, Basel II and Basel III was issued by the Basel Committee on Banking Supervision (BCBS). They are called the Basel accords as the BCBS maintains its secretariat at the Bank for
International Settlements in Basel, Switzerland and the committee normally meets there. The Basel Accords is a set of
recommendations for regulations in the banking industry.
Basel III is a global regulatory standard that aims to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and leverage. It was implemented in response to deficiencies in the previous Basel II framework that were exposed by the global financial crisis. The goals of Basel III include improving the banking sector's ability to absorb shocks, reducing systemic risk, and increasing transparency. It establishes stricter capital standards, introduces capital buffers, and imposes new liquidity measures including the liquidity coverage ratio and net stable funding ratio.
This document discusses the major components of stress testing processes required by regulators. It covers economic scenarios, cash flow models, new business plans, capital consumption models, income/expense models, and capital ratios. Accurately modeling cash flows is challenging, as separate risk functions make aggregation difficult. Regulators expect banks to use competing risk models to simultaneously consider multiple risk factors. Data and model limitations remain issues for banks to address.
Basel II is an international banking accord that establishes capital requirements for banks. It aims to create an international standard for how much capital banks need to put aside to guard against financial and operational risks. Basel II includes three pillars: minimum capital requirements, supervisory review, and market discipline. It addresses deficiencies in Basel I by incorporating additional risk categories like credit and operational risk. Implementing Basel II poses challenges for Indian banks like increased capital requirements, the need for risk management expertise and technology investments. However, gradual implementation could help Indian banks migrate smoothly to the new framework.
Basel 3 is an update to the Basel Accords that aims to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and leverage. Key changes include tighter definitions of Tier 1 capital, a leverage ratio, countercyclical capital buffers, and new liquidity standards. The goals are to promote a more resilient banking system and reduce risk of financial crises. Basel 3 also seeks to address procyclicality concerns by promoting capital conservation and countercyclical buffers.
Basel II is an international standard that aims to strengthen the regulation, supervision and risk management within the banking sector. It improves upon Basel I by making capital requirements more risk sensitive and aligning regulatory capital more closely with underlying bank risks. Basel II consists of three pillars that cover minimum capital requirements, supervisory review, and market discipline. Implementation of Basel II varies across countries and regulators but aims to modernize capital adequacy standards to be more comprehensive and risk sensitive.
The document discusses the evolution of the Basel Accords from 1988 to the present. It highlights that:
1) Basel I, adopted in 1988, aimed to strengthen bank stability and create equal competition. However, it only considered credit risk and encouraged regulatory arbitrage.
2) Basel II, introduced in 2004, aimed to make capital requirements more risk-sensitive by incorporating banks' internal risk management. It included three pillars for minimum capital, supervisory review, and market discipline.
3) While Basel III, finalized in 2010 after the financial crisis, aims to mitigate past damage, the results of its stricter capital standards are still to be seen as countries implement its guidelines.
Impact of Basel III on business of Indian Banks.pptxssuserffce38
This document provides an overview of the Basel III accord. It discusses the limitations of Basel II in addressing the global financial crisis, including its lack of emphasis on liquidity and leverage. Basel III was created in response to strengthen regulations. Its main objectives are to promote a more resilient banking sector and improve the ability to withstand financial stress. The key building blocks of Basel III include reforms to capital requirements, introducing stricter criteria for capital instruments and higher minimum thresholds. It also includes introducing a leverage ratio, capital conservation buffer, and countercyclical buffer to limit procyclicality.
The document discusses the Basel II Accords, which establish international standards for banking regulations and capital requirements. Basel II aims to make capital requirements more risk-sensitive by measuring credit, operational, and market risks. It introduces a three pillar framework: Pillar 1 sets minimum capital standards; Pillar 2 establishes supervisory review; and Pillar 3 promotes market discipline through disclosure. Implementation of Basel II varies by country and bank sophistication in risk measurement. The overall goal is a safer, more stable global banking system.
Basel iii Compliance Professionals Association (BiiiCPA)
http://www.basel-iii-association.com
The Basel iii Compliance Professionals Association (BiiiCPA) is the largest association of Basel iii Professionals in the world. It is a business unit of the Basel ii Compliance Professionals Association (BCPA), which is also the largest association of Basel ii Professionals in the world.
Receive (at no cost) the New Member Orientation newsletters:
http://www.basel-iii-association.com/New_Member_Orientation_Newsletters.html
Subscribe to Receive (at no cost) Basel II / Basel III Related News, Alerts, Opportunities, Updates, our Monthly Newsletter and Limited Time Offers for our Basel II / Basel III Training and Certification Programs:
http://forms.aweber.com/form/42/1586130642.htm
The impact of Basel III, also known as The Third Basel Accord, will vary by geography -- from potentially slowing down economies in emerging nations, to protecting the European Union from financial collapse, to increasing capital adequacy and improving risk management. Given the framework and timeline for implementing Basel III, the burden falls on national regulators to translate the international guidelines into national policies that suit and stabilize their economic environment and support economic growth.
Basel III is an international regulatory framework that aims to strengthen bank capital requirements and introduce new regulatory requirements on bank liquidity and leverage. It was implemented in Bangladesh to improve regulation of banks and address shortcomings of previous Basel accords. Key aspects include higher capital conservation buffers, a countercyclical capital buffer, and eliminating tier 3 capital. The buffers were phased in fully by 2019 and must be met with high-quality Common Equity Tier 1 capital to ensure banks can withstand periods of financial stress. Basel III thus enhances capital standards and promotes a more stable and resilient banking sector in Bangladesh.
The document discusses the Basel Committee on Banking Supervision and the Basel Accords. It provides background on the BIS and establishes that the Basel Committee published Basel I in 1988 to establish minimum capital requirements for banks. Basel I focused on credit risk and classified assets into risk weight categories. It aimed to strengthen stability in international banking and decrease competitive inequality. However, Basel I had limitations like simplistic risk differentiation and a static view of default risk. This led to the development of Basel II.
The Basel Committee was formed by central bank governors of G10 countries to enhance banking supervision worldwide. It is best known for its capital adequacy standards. Basel I (1988) focused on credit risk capital requirements. Basel II (2004) added operational risk and market risk requirements, and introduced three pillars for minimum capital standards, supervisory review, and market discipline. Basel III (2010) was introduced after the 2008 crisis to strengthen banks' capital reserves and introduce leverage ratios and liquidity requirements to improve financial stability. The three pillars of Basel II were retained in Basel III to balance bank stability and transparency.
1. A Better Measure to Regulate the Banks: Introduction to the Stress Test
Minghui Lu (lminghu1@binghamton.edu)
I. Introduction
1.1.Why the BanksNeededtoBe Regulated
1.2.Federal Reserve’s SupervisoryTools
II. Two ApproachestoMeasure Capital Adequacy
I.1. The Basel Accords
I.2. The Dodd-FrankActStressTestand Comprehensive Capital AnalysisReview
I.3. Why StressTestIs A BetterMeasure thanBasel Ratio
III. 2014 DFAST andCCAR Implementations
I.4. The 2014 DFASTResults
I.5. The 2014 CCARResults
IV. Conclusion
V. Appendix 1(a) and1(b):MinimumCapital RequirementsandResultof 2014 CCAR Capital Ratios
VI. List of References
2. I. Introduction
The 2008 financial crisiswasaconsequence tothe “burstof housing bubble”:the assetprices
declineddrasticallysince2007, causingmassive amountof defaultsonmortgages.Banksalsosuffered
fromthe fallingassetprices,causinglossesincapital andmanyof the banks became insolvent. Asa
result,in2008 manymajorfinancial institutionssuchas Bear Stearnsand LehmanBrothers hadto
announce bankruptcy,whichprovokedgreaterfear andonthe market.Investors became more risk
averse and startedto sell out equitiesandassetsontheirhandsto cut off furtherlosses.Due tothe loss
of confidence,equities andreal estate marketplummetedandindicated the whole USeconomy was
slowlydraggedintoone of the greatestrecessionssince 1920’s.
1.1.Whythe Banks NeededtoBe Regulated
Withthe unwindingof thisfinancial crisis, the publicfoundoutthatthe problemsoriginated
fromthe bankers’ excessivegreedinessandambition.The USeconomywas growingina steadypace
back ina fewyearsbefore the crisis.Givensuchafortunate outlookof the economy,the banksbeganto
offer“subprime mortgages”:whichisakindof mortgage offeredtoindividualswith higherleverage
ratioand lowercredit score requirement.Thismove furtherfedupthe optimisminthe marketand
made more people tobelieve thatthe surgingassetpriceswouldneverfall.Butthe truthis,once the
assetpricesincreasedtocertainlevel,the bubble wouldburstandthe price would eventually decline.
By thenthe U.S. was alreadytoo deepindebted; individualwhoborrowedthe subprime mortgageswere
no longerable to repaythe loansand had to defaultonbanks.The panicsweptthroughthe real estate
marketand causedhighertidesof defaultsandprice decline.
As a resultof pursuinghigherprofits,the bankshave containedtoomanyso-calledtoxicassets
on theirbalance sheets.Toxicassetshadthe feature of highrisk, whichgave themhigherdefaultrate
and couldeasilywipe outbanks’assetsvalue asthose subprime mortgagesdefaulted.Inotherto
maintainsolvency,the banksneededtosell some of the assets inlowerprices toreduce leverage ratio.
However,sellingassetswhile price plummeted wouldnothelpmuch,andundercapitalization of banks
alsospread fearin the marketand reducedinvestors’confidencetothe bankingsystems. The
governmentsawthatpanicsellingonequitiesandassetsmarketshasledtoan unavoidablerecession;
the onlysolution tostopthissituationandto restore confidence was bycapital injectionsintothe banks
usingthe publicfunds,which wouldeventuallyincreaseburdentothe taxpayers.The greedinessof
bankersinducedboththe banksandthe publicto undertake extrarisks.Deregulationandfailure to
correctlyassessthe risks inthe bankingindustry resultedinanational recession.Ultimately,the
governmentandtaxpayers bothhadtopay for this mistakes.
3. 1.2.Federal Reserve’sSupervisoryTools
The financial crisisexposedthe absence of anefficientregulatorymethodthatcouldmeasure
capital risk.Before the crisis,the global bankingindustry (includingthe U.S.) adaptedtothe socalled
Basel Accords(Basel Iand II) that evaluate capital adequacyof banksbymeasuringavarietyof capital
ratios.However,the Basel IandII modelswere proventobe insufficientbecauseithas underestimated
the creditrisksduringthe financial crisis.In2009 the Federal Reserve played the role of asupervisorand
implemented the ComprehensiveCapital AnalysisReview (CCAR) andthe Dodd-FrankActStressTest
(DFAST).The Fedbelievedthese tworegulatorytoolscouldbetterevaluate the capital riskof eachBHC,
and improve the financialsystem’sresilienceandrobustness toadverse economicconditions.
Thispaperwill introduce the historyof the twoapproachescurrentlybeingusedtoassess and
to supervise capital adequacy of BHCs:the Basel modelsandthe stresstest.Thenitwill examinehow
the Federal Reserve incorporatedthe stresstestintothe CCAR assessmentstoregulate the BHCs.
Furthermore,itwill discussthe weaknessesembeddedwithinthe Basel modelsandhow the stresstest
approach couldeffectivelyeliminatethem.Inthe final sectionitwill illustrate the resultof the 2014
CCARassessmentand DFAST;basesonthe result,itwill show the CCARandDFAST’sabilitytoimprove
financial stability byrequiringthe BHCstoraise capital buffer or to choose a more securedcapital
distributionplaninresponse topotentialadversescenarios.
II. Two Approaches to Measure Capital Adequacy
The regulationof banks’capital adequacywithinthe UnitedStatescouldbe tracedbackto the
periodafterWorldWar II. However,atthattime the Federal regulatoryagenciesdidnotdirectly
monitoror issue any minimumcapital requirementtothe banks;instead itprovidedasetof
recommendedcapital ratios forthe bankstofollow.Withoutamore directintervention,the regulatory
agencies wasineffective topreventthe declineincapital ratiosamongthose banks. A more formal
regulatory capital standardratios to the BHCs, whichnow commonlyreferred asthe Basel I Accord,was
finallydeveloped bythe Basel CommitteeonBankingSupervision (BCBS) onJuly15,1988. The BCBS was
establishedbythe central bankgovernorsof a groupof tencountries (the G-10) back in 1974; since then
the Basel I Accord became aninternational agreementadopted notonly bythe US banks,butalso in
manyEuropeancountriesaswell.The BCBSmade major modificationstothe Basel Iduring2004 and
2010 to fix up some of the weaknessesinthe Basel I,andwe referthese new versionsasthe Basel IIand
Basel III.However,duringthe 2008 financial crisis,peoplefoundoutthatthe Basel Accordscouldnot
fullyaccessthe defaultriskin the bankingindustrybyjustrequiringthe banksto reach a certaincapital
ratiosstandard.In the meanto fix thisproblem, the Federal Reserveintroducedthe Dodd-Frank Act
4. StressTest(DFAST) starting andthe ComprehensiveCapital AnalysisReview (CCAR) in2011. Both the
DFASTand CCAR functionasregulatorytoolsforthe government,inwhichthe 19largestbank holding
companies(BHCs) operatingwithinthe USmustreporttheirstresstest resultstothe Federal Reserve.
WheneveraBHC didnot achieve the capital requirementsetbythe government,theywouldbe
requiredtoincrease theircapital level until meetingthe standard.Nowadaysthe stresstestingmethod
has been routinelyperformedinmanycountriesonthe world.
Thissectionprovidesasummaryof how the Basel Accords,DFAST,andCCAR function to
measure capital adequacyinthe bankingindustry;thenitwillexplainwhy the federal stresstestingwas
consideredtobe a more advance assessmenttool thanthe Basel Accords.
2.1. The Basel Accords
The Basel I was firstestablishedtosetupan internationallystandardizedcapital ratios
measurementin1988, and firstadoptedbythe Group-of-Tencountries(G-10). The processof
estimatingcapital adequacyunderthe Basel I framework wastoseparate eachbank’s assetsbasedon
theirrelative risklevel intoone of fivecategories.The riskweightedassets(RWA) wascalculatedby
multiplyingthe risklevel andthe weightspercentageof assets ineachcategory,and thensummingup
all five categoriesandgetthe total RWA value.The banksusedthe tier1 capital,whichconsists of the
commonand preferredequity, todividebythe RWA and to getthe tier1 commoncapital ratio. Other
regulatorycapital ratiossuchas tier1 equitycommonratiowas obtainedwithasimilarmethod.
Accordingto the Basel I,all banks neededto meetthe minimumtier1commoncapital ratio of 4
percent.However, thisratiocouldnotaccuratelymeasure creditrisksince “the measurement
discouragedthe accumulationof lowriskloantothe private sectorwhile encouragingbankstotake
risksthat were underweightedbythe standard”accordingto (Wall,2013). Thus the bankswouldpursue
higher-returninvestmentwhichthe riskwasunderestimatedby the Basel Iregulation.Inordertocover
the loophole,in 2004 the rules hasbeenrevisedandwas thencalledthe Basel II.Inaddition tothe Basel
I’smeasurementwhichsolelyreliedonthe probabilityof default,the Basel IIaddedinextrafactors inits
calculation suchas exposure atdefault,lossgivendefault,andeffectivematurity. Basel IIprovidesthree
differentmeasuresof capital adequacy(3pillars).The standardizedapproachreliesonlevelRWA ratio
to showrelative riskinessof differentbanksexposures.The internal ratingsbased(IRB) andadvanced
IRB approachesuse historical datatoestimate expectedcapital losses.
Evenwithtakingextrafactorsintoconsiderationandusingamore complex formula,the Basel II
ratiowere still proventounderweightcredit risk. Furlongnotedthatthroughout 2007 and2008, the
large bankholdingcompanies,includingthe majorfinancialinstitutionswhofailedduringthe financial
5. crisis, still reportedthe tier1commonratioto be above 8 percenton average.Thisfactsufficiently
showedthatthe Basel approaches(Iand II) couldnot accuratelyrepresentthe real risklevel.
In the attemptto restore investors’confidence,the BCBScalledfora review onthe Basel II
standardand made furthermodificationstothe model.The revision,asknownasthe Basel III,was
issuedbythe BCBS inDecember2010. It incorporatedseveral changes,including“new limitationsonthe
instrumentsthatqualifyascapital,enhancedriskcoverage,the adaptation of anew leverage
requirement,countercyclical capital buffers,andnew minimumliquiditystandards”(Wall,2013).The
adaptationof the Basel IIIenhancedthe reliabilityof the Accords;however,Wall arguedthatcompares
to the stresstests,there were still certainweaknessesexistedin the Basel IIImodel, whichwill be
discussedinthe subsection 2.3.
2.2. The Dodd Frank Act Stress Test and Comprehensive Capital AnalysisReview
In the financial world, stresstestare usedtotestthe abilityof financial institutionstowithstand
an adverse economicenvironment.Usuallyone ormore setsof hypothetical scenarioswithseveral
variables were usedin indicatingaweakeconomy (suchasdramaticincrease of unemploymentrate,
decline of GDP,andchange of interestrate,etc.).These financial institutionshave startedtoconduct
internal stressteststoevaluate theirowncapital adequacy since 1990’s. In2009 the Federal Reserve
Systemannouncedthe initiation of the SupervisoryCapital Assessment Program(SCAP).The Federal
Reserve,the Officeof the Comptrollerof the Currency(OCC),andthe Federal DepositInsurance
Corporation(FDIC) became the federal supervisorstoconductthe SCAP. The 19 largestdomesticBHCs
witha total assetexceeding$100 billion wererequiredto runthe stresstestannually and“projectthe
losses,revenues,andloanlossreserve needsoveratwo-year,forwardlookinghorizonundertwo
economicscenarios (baseline, andseverelyadversescenarios) providedbythe supervisors”(Beverlyet.
al,2009). The institutionswho failedthe stresstests were requiredto increase theircapital bufferby
issuingnewcapitals.
In a Federal Reserve Bank of New YorkStaff Report(2009), the authors illustrated animportant
functionof the SCAP.Inthe report,BeverlypointedoutthatSCAPhadfeaturesof “macroprudential and
microprudentialsupervision”(Beverlyet.al,2009). To restate itin a more comprehensible way:the
stresstestnot only independently evaluatedthe resilience of eachcompanies andprovidedprotections
to ownersandinvestorsof specificfirmsduringthe adverse economiccondition (microprudential
regulation);italsoassessedthe financial stability of the entire USeconomy bypoolingthe estimated
lossesof eachBHC, and to determinethe appropriate amountof capital buffersuchthatthe economy
6. 1 See Appendix 1(b) for the exact regulatorycapital ratios standardunder each period.
wouldsufferthe leastamountof losses fromthe riskscausedbyindividual firms(macroprudential
regulation).Thisstatementshowsanadvantage of runninga standardizedstresstestsupervisedbythe
government,which allowedthe supervisors tothoroughlyconsiderthe risksina national scale rather
than withineachcompany.
Buildingon the SCAP,the Federal Reserve alsoranthe stresstestsasa part of the
ComprehensiveCapital AnalysisandReview (CCAR) startingin2011. As a complementarypartof the
CCAR,the section165(i)(2) of the Dodd-FrankWall StreetReformandConsumerProtectionAct (the
“Dodd-FrankAct”) statedthat all the financial institutionswithasize of assetsover$10 billion (occ.gov)
were subjectedto annual mandatory stresstest(DFAST);eachcoveredcompanywill be given three
economicscenarios (baseline,adverse,andseverelyadverse scenarios) providedbythe supervisors.
Additionallylarge BHCswere requiredtoconducttheirownsemiannualstresstestsusingtwoof their
ownsuppliedscenarios. Accordingtothe Boardof Governorsof the Federal Reserve System (BoGoFRS),
the stresstestaims “to ensure thatlarge financial institutionshave robust,forward-lookingcapital
planningandsufficientcapital tocontinue operationsthroughouttimesof economicandfinancial
stress”(BoGoFRS,2013). In orderto passthe stresstest,eachBHC needstomaintainthe post-stresstier
1 commonratioexceeding 5percentandpost-stressregulatorycapital ratiosabovethe minimum
requirements (1)
.Andalso,the coveredinstitutionsneededtosubmittheirproposed capital distribution
plans(share buybackandissuingdividends) inthe nextfourquarters forFederal Reserve approval.The
supervisorswould assessthe capital distributionplanqualitativelytoensure the bankshave reasonable
assumptionsandanalysiswhenplanningthe future risk-managementpractices.Inaddition,the CCAR
alsorequiredparticipantstoreporttheirabilitytomeetthe Basel IIIcapital requirements.
If the BHCs fail tomeetthe CCARstandard,insteadof mandatorilyraisingcapital, the Federal
Reserve wouldrejectsome BHCs’plansforcapital distributions,suchasthe sharesbuying-backand
issuance of dividends.Since suchcapital distributionplanswouldbe favorable toacompany’sstock
price, the BHCs wouldhada motivationtopassthe stresstestsinorderto effectivelyexecute their
capital distributionplans.
Despite of the close connectionbetweenthe Dodd-FrankActStressTestandthe Comprehensive
Capital AnalysisReview,there issignificantdifferenceonthe capital actionassumptionswiththesetwo
projections.Bythe DFAST,the Federal Reservewoulduse astandardizedsetof capital action
assumptions, suchasassumingcommonstockdividendpayoutrate isconstantoverthe year; scheduled
dividend,interest,principal payments,orissuance of commonstockwouldnotbe takenintoaccount. In
7. contrast,the CCARwouldadjustthe capital level accordingtothe change of commonstock or dividend
level inthe test.Asa result,the ratioestimatedby the DFASTandCCARshouldexpecttobe different.
2.3. WhyStress Test Is a BetterMeasure than Basel Ratio
The Basel Accords have beendevelopedforovertwodecades.These modelshave always
functioned asthe mostimportantregulatory assessmentof capital adequacy inthe U.S. until they were
proventounderestimate creditrisksduringthe 2008 financial crisis.Afterthat,they were substitutedby
the CCAR andDFAST. Thisprovokedaquestiontothe supervisors:How couldstresstestbetterevaluate
the capital adequacyof the BHCs thanthe Basel models do?Thissubsectionwillillustrate the difference
betweentwomeasures andthe features thatstress testhasand are notexisted inthe Basel ratio.
Firstof all,the Basel modelsrely onthe historical datato forecastthe bank’slossdistribution
function inthe future withvariousassetcategories.These distributionswere usedtoestimatethe
probabilityof lossesandamountof capital buffereachbankshouldpossesstopreventfrominsolvency.
The Basel II model calculatedthe requiredcapital buffer ata 99.9% level of confidence, whichmeans
that the bankswho have highenoughcapital ratio shouldexpecttosufferalossexceedingtheircapital
level only once inathousandyear.However,since all the numbersbeingusedtoforecastthe loss
distributionswere takendirectlyfromthe historical dataorfrom the financial statementsof the bank,
thisestimationof expectedlosswouldonlyholdtrue if the economycontinue itsmoderate growthpace
similartothe past fewyears.If facinga severelyadverse scenario likeswhathave occurredin2007, the
estimatedlossdistributionwouldnotaccuratelyreflectthe capital bufferneededforsucha shock.
In comparison,the stresstestallowsthe supervisorstosetup hypotheticaladverse scenarios
that have not been observed inthe recentpastbutplausible tooccurin the future. Suchas a decline of
GDP and assetprices,or increase of interestrate thatleadto reductionin assetvalues.Thenthe BHCs
needtocome upwiththe appropriate capital allocationplantoensure sufficientcapital levelatthe end
of one or more periods.The projectiononrequiredcapital bufferbasedon specificadverse scenarios
couldbetterhelp toprepare foran unexpecteddownturnof economy inreal life.
The secondweaknessof the Basel ratioisthat the model onlymeasurescapital adequacyat a
single pointintime.Thusif the eachfirmscalculate the Basel ratiosbyplugginginaccountingvalueson
theirfinancial statements,the ratioswouldonlyreflectcapital adequacy uptothe pointof the issuance
of the financial statement;thusthe expectedlossesinfuture wouldnotbe recognized.Whilethe Basel
ratiosare static,the stresstestmeasure ismore dynamic.The stresstest have a longertime horizon; the
supervisorsrequire BHCstoreportcapital sufficiencyeachquarterwithinthe time horizon,foratotal of
nine periods.Eventhoughthe stresstestsalsoreliedonaccountingmeasure of capital,the longtime
8. 3 See Appendix 1(a) for the results of minimum capital ratios andtier 1 common ratioin2014 CCAR.
horizonandactive adjustmentof capital levelwouldallow bankstoforeseepotential losses ineach
particularscenario thatare unable to recognize undercurrentdata.
Furthermore,Wall (2013) providedseveral otherreasonstoexplainwhyBasel ratiosmightnot
be a goodmeasurement of risk.AccordingtoWall,the BHCscouldintentionallyshrinktheiroverall
portfoliowhile retainingthe same allocationof capital inorderto “reduce risk”.But “the reductionin
the supplyof creditsmighthindereconomicgrowth (ordeepenarecession)”(Wall,2013).Andalso,
Wall was concernedthatbanksmightchoose data and modelsthatproduce the lowestriskweights.This
wouldnotbe a probleminthe stresstestsbecause the supervisorswouldprovide astandardizedmodel
for the BHCs to use.
III. 2014 DFAST and CCAR Implementations
Thissectionisgoingto examine the resultsof the 2014 Dodd-FrankAct StressTest(DFAST) and
ComprehensiveCapital AnalysisReview (CCAR).
3.1. The 2014 DFAST Results
The Dodd-FrankAct requiresthe FederalReservetoconductan annual supervisorystresstest
on large BHCs and all nonbankfinancial institutionswithatotal assetsvalue over$10 billion (2)
.The
Federal Reserve wouldprojectthe netrevenue,netlosses,the post-stresscapital level,andthe
regulatorycapital ratiosbasedonthe givenscenarios. Inaddition,the Dodd-FrankActrequiresthe
coveredcompaniestoconducttwocompany-runstresstestseachyear.The BHCs withassetsover$50
billionmustalsoconducta“mid-cycle”testandreportthe resultto the Federal Reserve byJuly5.
Under the stresstestrules,byeachNovemberthe Office of the Comptrollerof the Currency
(OCC) wouldprovide threeidentical setsof scenariosforboththe supervisoryand the company-run
stresstestthat are classifiedbydifferent stresslevels (baseline,adverse,andseverelyadverse).Each
scenarioincludedatotal of 28 variables;16 of them capture the economicactivities,assetprices,and
interestrate inthe US economyand the remaining12 variablesare real GDPgrowth,inflation,and
exchange rate withinthe 4country blocks.Withinatime horizonof nine quarters, the severelyadverse
scenariofeatured “adeeprecessioninthe UnitedStates,Europe,andJapan,significantdecline inasset
pricesand increasesinriskpremia,andamarkedeconomicslowdownindevelopingAsia”(2014 DFAST
Result,2014). The adverse scenario depicted a“weakeningineconomicactivitiesacrossall countries
and deepenof yieldcurve”.Inordertomore accuratelypredictglobal marketshocks,6BHCs withlarge
tradingand private-equityexposuresandhighercounterparty riskswill be subjected totwomore
variables intheiradverse andseverelyadversescenarios.
9. 3 See Appendix 1(a) for the results of minimum capital ratios andtier 1 common ratioin2014 CCAR.
The Federal Reserve introducedsome keychangestothe 2014 DFAST.In the stresstest,the
Federal Reserve independentlyprojectedthe balance sheetandrisk-weightedassets(RWAs) foreach
BHCs. Thisimprovementhelpedtopreventcapital mismeasurement. Furthermore,the 2014 DFAST
adapteda revisedcapital frameworkthatimplementedthe Basel IIIregulatorycapital reform.The
revisedframeworkaddedanewcapital ratio(tier-one equityratio) andaffectedothersregulatory
capital ratiosas well bychangingthe risklevel ineachassetcategory.Finally, the Federal Reservealso
disclosedthe resultsof stresstestconductedunderthe adverse scenario inthe 2014 DFAST report,in
comparisontoonlydisclosingseverelyadversescenarioresultsinthe past years.This change enhanced
transparencyandprovidedthe riskcharacteristicstothe publicof eachBHCs basedon theircapital
actions.
The resultof 2014 DFASTsuggestedthat overthe nine-quarterperiodall of the 30 BHCs who
participatedinthe testwouldexpectedtoexperience anaggregatedlossof $217 billionunderthe
severelyadverse scenarioandanexpectedlossof $130 billionunderthe adverse scenario.The
substantial losseswouldleadtoa dramaticdecrease of tier1 commonratio,from11.5 percentinthe
thirdquarterof 2013 to a post-stresslevel of 7.8percentinthe fourthquarterof 2015.
3.2. The 2014 CCAR Results
In March 2014, the Federal Reserveannouncedthe resultof the 2014 ComprehensiveCapital
AnalysisReview.Compare tothe previousyear,the 2014 CCAR covered30 large BHCs, 12 of themnewly
joinedthe CCARexercises.The CCARrequiredthese 30BHCs (withaconsolidatedassetsover$50
billion)tosubmitanannual capital distributionplantothe Federal Reserveforreview.Accordingtothe
report,the capital planmust include the following:“the BHC’s internal processesforassessingcapital
adequacy;the policiesgoverningcapital actionssuchascommon stockissuance,dividends,andshare
repurchases”(CCAR2014 assessmentFrameworkandResult,2014).The submittedplanswouldbe
assessedby over120 economistsandanalystsinFederal Reserve,bothquantitativelyand qualitatively
to determine whetherthe planscouldprovide the BHCsarobustprocesson managingtheircapital
resources.Accordingtothe Dodd-FrankAct,eachcoveredcompany mustconduct the DFASTand reach
the minimumregulatorycapital ratiosleveloveranine-quartertime horizon.The capital plansthatgot a
below-standardratioduringanytime periodinthe stresstestwouldbe consideredasquantitatively
unqualifiedandneedtoresubmitanadjustedproposal.
The qualitative assessmentcarriedoutbythe Fedwas importantbecause eachBHCparticipated
inthe CCARdifferedsignificantlyinsize andcomplexity;andeachcompanyisexpectedtoface specific
idiosyncraticriskswhile conductingthe stresstestandthese riskscouldnotbe fullycapturedbythe
10. 3 See Appendix 1(a) for the results of minimum capital ratios andtier 1 common ratioin2014 CCAR.
numerical resultof astandardizedtest. Therefore evenif aBHC passedthe stresstest,the Federal
Reserve mayobjecttothat BHC’s capital planbase on qualitativereasons.
Overthe thirty BHC’s whosubmitted 2014 capital plans,the Federal Reserve hasrejectedfive of
them,includingCitigroupInc.,HSBCNorthAmericaHoldingsInc.,RBCCitizensFinancial Group,
SantanderHoldingUSA,Inc.,and ZionsBancorporation.All fourotherbankswere rejectedbasedonthe
qualitative reasonexceptforZion.
The Federal Reserve’s reasonstoreject Citigroup’scapital planreflectedthatthe Fed hadhigher
expectationforthe large andcomplex BHCs.The Fedobserved Citigroup’s inability toprojectrevenue
and lossesusingamore sophisticatedmodel andits inabilitytoadequatelyreflectriskinvolvedin itsfull
range of businessactivitiesinthe internal stresstest.Incontrast,the HSBC,Santander,andRBS Citizens
were bothnewto the CCARpractices,and they were unable todevelopappropriatecapital planning
processto meetthe Fed’sexpectation due tothe deficiencyinestimatingrevenue and loss,andalso
lack of governance andinternal control duringthe process.
Out of all the BHCs thatconductedthe DFAST in2014, these three BHCs – Bank of America
Corporation,GoldmanSachsGroup,Inc.,and ZionBancorporationwere projectedtofail inmeetingthe
regulatorycapital ratio onat leastone periodbasedontheiroriginal plannedcapital actions.After
resubmission,GoldmanSachsandBankof Americawere able topassthe stresstest, while Zionsdidnot
resubmititscapital action (3)
.
Since the 30 BHCs hold 80 percentof the total assetsof all U.S. BHCs, conductingthe CCAR
wouldimprove the financial resilience inthe bankingindustrybyincreasing the capital holdings.A graph
suggestedthatthe aggregatedtier1 commonequityratioof the 30 BHCs doubledfrom5.5 percentin
the firstquarterof 2009 until the thirdquarterof 2013. The increase incapital ratiowouldeffectively
strengthenthe banking industry.
IV. Conclusion
The decline of house pricesinthe U.S.at the endof 2007 turnedout to be an unexpected
disaster:Banksandfinancial institutionsstarted lendingmoneytoindividualswithlow creditscores
whenthe US economywasbenign.A lotof people hadlimitedknowledgeaboutthe market still turned
intoaggressive speculatorsbecause the stronggrowthinreal estate pricesshowednosignal of slowing
down.The combine of twofactors ledthe housingbubble toswellupintoanenormousmonster.When
the housesprice showedaslighttendencytodecline,manyinvestorswhoborrowedthe subprime
mortgagescouldnotaffordto repayand had to defaultonbanks.The continuingdecline inthe real
estate marketcreateda bigwave of defaultsandeventually,some financial institutionsbecame
11. insolventbecause of the evaporation of assets.Majorfirmssuchas Bear Stearnsand LehmanBrothers
were caughtintothiscrisisand had to file forbankruptcy.Thisfurtherdeepenedthe fearonthe market
and eventuallyledthe entire economy fellintogreatrecession.All of thesewere causedbythe
deregulationof the financial institutionsandbankholdingcompanies(BHCs),whichimposedgreatrisks
not onlytothe firms,butalsoto the economy.
One of the lessons people learnedinthe 2008 Financial Crisiswasthatthe existingregulatory
measuresof capital adequacytothe financial institutions were notstrongenough.Until 2007, the U.S.
have beenusingthe Basel modelstomeasure the capital ratios of afirm.However,the Basel ratioshad
several weaknessesandtendedtounderestimate the creditriskswithinthe industry.Inordertorestore
confidence onthe market,the Federal Reserve initiatedthe SupervisoryCapital AssessmentProgram
(SCAP) in2009 and required19 majorbank holdingcompaniestoconductmandatorystresstests.Inthe
stresstestthe coveredcompanieswouldneedtomeetasetof capital ratiostandards undera varietyof
adverse scenarios. Buildingonthe SCAP,the governmentpassedthe Dodd-FrankActin2010 and
demanded eachlarge BHC(withtotal assetover$10 billion) notonlytoconducta standardized
supervisorystresstest(DFAST) everyyear,butalso reportthe result tothe Federal Reserve.
Furthermore,the Federal Reserveimplementedthe ComprehensiveCapital AnalysisReview (CCAR) to
BHCs withover$50 billiontotal assetsandrequiredthemtosubmitaproposedcapital distributionplan
annually.The Fedwouldassessthe creditriskineachbanksbasedonboth theirproposal andresultof
the DFAST andthendeterminedwhetherthe BHCscouldretainsufficient capital level towithstand
possible adverseshocksinthe future.
Giventhe two differentapproachestomeasure capital adequacy,intwoof hisworkingpaper
Larry D. Wall arguedthat the stresstestwouldbe a betterregulatorytool usedtomeasure capital
adequacythanthe Basel modelsbecause the stresstestis more dynamicandmore considerate toeach
particularscenario. Wall pointedoutthat the stresstestcouldmitigate manyestimationerrorscreated
by mismeasurementinthe Basel modelsbecause stresstestscenarioscould include specificrisk
componentstothe scenarioandextendtolongertime span,suchthat the testedfirmswouldrecognize
potential lossesembeddedinthe future time andthus be able toeliminatethe mismeasurement.
In 2014, a total of 30 BHCs and financial institutionsparticipatedinthe CCAR.Theysubmitted
theircapital distributiontoFederal Reserve forapproval.Inaccordingtothe Dodd-FrankAct,theywere
alsorequiredtoconducta supervisorystresstestandtwocompany-runstresstests underthree
hypothetical scenarios(baseline,adverse,andseverelyadverse scenarios)providedby the Office of the
Comptrollerof the Currency (OCC). The Federal Reserveevaluatedthe capital planforeachcovered
12. companyand decidedtorejectfive of the BHCs’proposalsfor eitherqualitativeorquantitativereasons.
The resultof 2014 CCARand DFASTsuggestedthatthe Fed maintainedhighexpectationstoeachBHC
and imposedhighstandardstotheircapital adequacyinordertoprovide a more robustfinancial
system.The numerical evidence alsosupportedthatbyconductingthe stresstests,the BHCs were
expectedtoendure asubstantial aggregatedlossunder bothadverse andseverelyadversescenarios.
Therefore the average tier1equitycommon ratio(whichisone of the mainregulatorycapital ratios
usedinthe stresstest) doubledfrom2009 to the lastquarter of 2013, whichshowedthatthe BHCs have
become more preparedforpotential futurecreditcrisis.
13. IV. Appendix 1(a) and 1(b): Minimum Capital Requirements and Result of 2014 CCAR Capital Ratios
(Source: Board of Governors of the Federal Reserve System, Comprehensive Capital Analysis and Review 2014:
Assessment Framework and Results, p13)
14. VI. List of References
Board of Governorof the Federal Reserve System.(2015Feb.13). 2014 Supervisory ScenariosforAnnual
StressTests Required underthe Dodd-FrankActStressTesting Rules and the CapitalPlan Rule. 1-28.
Retrievedfrom http://www.federalreserve.gov/bankinforeg/bcreg20131101a1.pdf
Board of Governorof the Federal Reserve System.(2015Feb.13). ComprehensiveCapitalAnalysisand
Review 2014 Summary InstructionsandGuidance.1-48.Retrievedfrom
http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20131101a2.pdf
Board of Governorof the Federal Reserve System.(2015Mar. 26). ComprehensiveCapitalAnalysisand
Review 2014: AssessmentFrameworkand Results.1-30.Retrievedfrom
http://www.federalreserve.gov/newsevents/press/bcreg/ccar_20140326.pdf
Board of Governorof the Federal Reserve System.(2015Feb.19). Dodd-FrankActStressTest 2014:
Supervisory StressTestMethodology and Results.1-82.Retrievedfrom
http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20140320a1.pdf
Fratianni,Michele,&Marchionne,Francesco.(2015 Mar. 16). The Role of Banksin the Subprime
FinancialCrisis. 1-38. Retrievedfrom http://kelley.iu.edu/riharbau/RePEc/iuk/wpaper/bepp2009-02-
fratianni-marchionne.pdf
Hirtle,Beverly;Schuermann,Til,&Stiroh,Kevin.(2015 Mar. 24). MacroprudentialSupervision of
FinancialInstitutions:LessonsfromtheSCAP.1-17. Retrievedfrom
http://fic.wharton.upenn.edu/fic/papers/09/0937.pdf
Touryalai,Halah.(2015 Feb.19). Wall Street’sMarch Madness:Whatto Know aboutBankStressTests.
Retrievedfromhttp://www.forbes.com/sites/halahtouryalai/2014/03/19/wall-streets-march-madness-
what-to-know-about-bank-stress-tests/
Wall,Larry D. (2015 Feb.19). Basel IIIand the StressTests. Retrievedfrom
https://www.frbatlanta.org/cenfis/publications/notesfromthevault/1312
15. Wall,Larry D. (2015 Feb.19). Measuring CapitalAdequacy Supervisory StressTestsin a Basel World.1-
26. Retrievedfrom https://www.frbatlanta.org/documents/pubs/wp/wp1315.pdf.
Wall,Larry D. (2015 Feb.20). The Adoption of StressTesting:Why the Basel CapitalMeasuresWere Not
Enough.1-21. Retrievedfrom
https://www.frbatlanta.org/media/Documents/research/publications/wp/2013/wp1314.pdf