Banking and Finance Law Daily GAO recommends changes to Fed’s stress testing programs
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Wednesday, November 16, 2016

GAO recommends changes to Fed’s stress testing programs

By Colleen M. Svelnis, J.D.

A study by the Government Accountability Office has reviewed the effectiveness and burdens involved with the Federal Reserve Board’s two stress testing programs, DFAST, which encompasses stress tests required by the Dodd-Frank Act, and Comprehensive Capital Analysis and Review (CCAR), and made recommendations including the need for greater transparency and accord between the Fed and other agencies. The GAO report, Federal Reserve: Additional Actions Could Help Ensure the Achievement of Stress Test Goals, analyzed documents including rules, guidance, and internal policies and procedures, and assessed practices against federal internal control standards and other criteria, and interviewed Fed staff and bank officials.

House Financial Services Committee Chairman Jeb Hensarling (R-Texas), who requested the study in September 2014, responded to the report, calling the findings "devastating." He stated that the report "confirms the secrecy surrounding the stress tests makes it almost impossible to measure the effectiveness of the Fed’s regulatory oversight or the integrity of the tests’ findings. When it comes to the Fed’s stress tests, not only are they not transparent, they are often duplicative and impose unnecessary costs and burdens on financial institutions that are ultimately passed on to consumers."

Findings. The GAO found limitations in the stress test programs that could hinder their effectiveness including lack of transparency and accountability. According to the report, the Fed has not regularly updated guidance to firms about supervisory expectations and peer practices related to the qualitative assessment. This limited communication can pose challenges to companies that must meet these expectations annually and could hinder the achievement of CCAR goals.

In addition, the study found that, although the Fed has a framework for designing stress test scenarios, its analysis of some key design decisions has been limited. Further, the report states that the Fed makes supervisory decisions based on the results of its own stress test models, but its management of model risk, which it uses to help make supervisory decisions, has not focused on its system of models that produce stress test results.

The report listed 15 recommendations to help improve the effectiveness of the stress testing programs including asking federal banking agencies to harmonize their approach to granting extensions and exemptions from stress test requirements. Additionally, GAO recommended that the Fed should:

  • remove company-run stress tests from the CCAR quantitative assessment;
  • publicly disclose additional information that would allow for a better understanding of the methodology for completing qualitative assessments;
  • disclose additional information about the reasons for the determinations to object or conditionally not object to a company’s capital plan on qualitative grounds;
  • publicly disclose, on a periodic basis, information on capital planning practices observed during CCAR qualitative assessments, including practices the Fed considers stronger or leading practices;
  • improve policies for official responses to CCAR companies by establishing procedures for notifying companies about time frames relating to Fed responses to company inquiries;
  • assess—and adjust as necessary—the overall level of severity of its severely adverse scenario.
  • assess whether a single severe supervisory scenario is sufficient to inform CCAR decisions and promote the resilience of the banking system; and
  • develop a process to test its proposed severely adverse scenario for procyclicality annually before finalizing and publicly releasing the supervisory scenarios.

With regard to the Fed’s ability to manage model risk and ensure that decisions based on supervisory stress test results are informed by an understanding of model risk, the report also recommended that the Fed:

  • apply its model development principles to the combined system of models used in the supervisory stress tests;
  • create an appropriate set of system-level model documentation, including an overview of how component models interact and key assumptions made in the design of model interactions;
  • design and implement a process to test and document the sensitivity and uncertainty of the model system’s output—the post-stress capital ratios used to make CCAR quantitative assessment determinations—including, at a minimum, the cumulative uncertainty surrounding the capital ratios and their sensitivity to key model parameters, specifications, and assumptions from across the system of models;
  • design and implement a process to communicate information about the range and sources of uncertainty surrounding the post-stress capital ratio estimates to the Board during CCAR deliberations; and
  • design and implement a process for the Fed to articulate tolerance levels for key risks identified through sensitivity testing and for the degree of uncertainty in the projected capital ratios.

The Fed, Federal Deposit Insurance Corporation, and Office of the Comptroller of the Currency generally agreed with the report’s recommendation to harmonize their agencies’ approach to granting extensions and exemptions from stress test requirements. The Fed generally agreed with the other recommendations.

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