While much of the focus and attention on stress testing has been driven by Dodd-Frank and the Federal Reserve’s Capital Analysis and Review (CCAR) exercise, the reality is that regulators now view stress testing as a reasonable and prudent risk management exercise that banks of all sizes should integrate into their risk management and financial forecasting activities. As we are finding out, banks will soon have no choice but to modernize their stress testing approach as regulatory changes are here to stay and even increasing in both frequency and complexity. The banks that are able to do address stress testing effectively will find that they are not only adhering to federal regulations, but they are also providing themselves with a forward-looking competitive advantage in the marketplace.
While stress testing encompasses the impact of adverse macro-economic scenarios on the entire bank, I have focused my comments below on the primary asset component of banks, which are loans. Up to now, banks have typically relied on a manual error-prone process to obtain their loan information which is compiled independently by multiple divisions based on aggregated historical data. By contrast, the new stress testing requirements will force banks to analyze loan-level data focusing on cross-functional future projections. This substantial shift in data granularity and outlook will involve a far more comprehensive analysis and an automated process that cuts across business lines.
Contrary to some of the rhetoric that has been common during Dodd-Frank’s regulation-drafting stage, complying with the stress testing regulations will not be impossible. It will, however, require that banks invest more in the effort and abandon the procedures that in some cases have been in place for years. At a high level, the need for better integration between the finance and risk teams will be paramount if banks want to be able to effectively handle ever-changing and ever-increasing regulatory changes and to better understand their loan portfolio’s performance under stress. Because finance and risk teams have traditionally not worked together, the most effective way to provide this integration is through the use of technology, realizing that a dependency on offline spreadsheets across multiple groups can be error-prone and detrimental to the end result.
Quite simply, banks that continue to try to satisfy regulators with spreadsheets and columns of numbers crunched monthly will find themselves in a major dilemma. With better insight into their loan portfolios and the ability to quickly synthesize what-if scenarios, banks will also provide themselves with a competitive edge in defending their capital plans. And with a well-integrated process enabled through technology, financial institutions can help ensure that they have a robust, forward-looking capital planning process to account for their unique risks, ultimately turning stress testing from a compliance standard to a strategic tool. To that end, banks that modernize and automate their loan accounting and valuation system will be able to more effectively deal with the major issues regarding stress testing regulatory compliance - ownership, complexity and process.
Ownership. Because they cut across the standard divisions in most banks, it won’t be clear which function or group should have the responsibility to comply with the new stress testing requirements. The proposed regulations will require something that has not typically happened in the past: the finance, risk, credit, modeling/forecasting and capital adequacy groups will all have to coordinate their efforts and combine their data. That will not be an easy change for culture that is accustomed to working in silos.
Complexity. Asking accountants to perform complex accounting on loans that don’t yet exist for various stress testing scenarios is always daunting. But, no matter how talented they are, asking CPAs to produce disclosures for nine future periods on loans that have not yet been created will be nearly impossible unless they have the right data, activity and baseline.
Process. New regulatory stress testing requires that banks to convert the economic output of the stress test into forward looking accounting results – income statements and balance sheets for future periods, meaning banks need to put in place a robust architecture that is capable of executing both loan accounting and stress testing. This simplifies the integration process and provides banks with a distinct ability to operate more strategically, turning a compliance concern into an innovative opportunity.
By now most bank executives have excepted that stress testing regulations are here to stay and that they’re going to be a compliance issue whether they want to adhere or not. With that said, the onset of stricter regulation coupled with innovations in financial technology brings about the unique capability to turn these regulatory burdens into a strategic advantage that gives banks insight into their capital planning strategies like never before. Banks that embrace the ownership, complexity and processes that go into effectively addressing stress testing and more broadly, Dodd-Frank, will be among those who will be most successful in the years to come.
Jeff Sant is the co-founder of Primatics Financial, a software provider for financial institutions.