2018 stress test once again reveals its forward-looking power to measure Capital at Risk and confirm Risk Appetite. Aggregate test results were positive reflecting substantial capital accretion since the financial crises offsetting the most severe iteration of the test yet which assumes 10% unemployment, crashing markets and soaring loan losses. All 35 participants cleared the severely adverse high jump, but what can we learn from the results?
Of particular interest to Strategic Risk Associates (SRA) is the capital depletion or Capital at Risk identified for each firm. It’s our view that Capital at Risk is the best forward-looking indicator of Risk Appetite. The larger the amount of Capital at Risk identified by a stress test the bigger a firm’s appetite for risk. Individual firm Capital at Risk correlates directly to its business focus, asset composition, revenue and expense sources, and portfolio risk characteristics.
Capital at Risk and Risk Appetite by Firm
Figure 11 below is from the Fed’s June 2018 DFAST report and illustrates the negative change or Capital at Risk for each participant in the severely adverse scenario over the nine-quarter test horizon. The starting point is 2017: Q4 which is compared to each firm’s minimum Common Equity Tier 1 (CET1) ratio. For example, Morgan Stanley’s CET1 ratio goes from 16.5% actual 2017: Q4 to a test minimum (low) point of 7.2%. A decline of 930 basis points or 56%. In the severely adverse case, Morgan Stanley’s CET1 ratio has 930 basis points of Capital at Risk which suggests a CET1 Risk Appetite of 930 basis points or greater.
At SRA, we use individual firm level stress test results to confirm a client’s consistency with established risk appetite goals and compare results with prior year’s test. For example, we examine a current year’s financial information and then run it through last year’s severely adverse scenario to highlight key changes in the results that are not due to the harsher scenario.
These stress test comparisons zero in on changes in risk profile and can be analyzed in terms of Capital at Risk.
Key loan loss data from the DFAST 2018 test is as follows:
Loan Losses: Severely Adverse DFAST 2017 loan losses totaled $383.1 million or 5.8% compared to DFAST 2018 loan losses of 6.4% shown below:
Loss rates by portfolio are higher than last year due to the harsher test scenarios and corporate lending losses increased reflecting rapid growth.
Next Steps and Strategic Risk Associates
We at SRA, see a firm’s ability to measure, reconcile, and manage Capital at Risk as vital to its business. Just like the Fed looks at the Capital at Risk and Risk Appetite of large and complex firms, we recommend a stress test every 12 to 18 months to confirm your firm’s risk appetite, short-term tactics, and long-term strategy.
There are a variety of stress tests, however, a good stress test is one that returns plausible results and is readily understandable. Stress tests performed by Strategic Risk Associates are grounded in the client’s risk profile, asset cash flows, and include the following attributes:
1. Whole firm tests–i.e., all assets (not just loans) and contingent liabilities are stressed;
2. Utilize three scenarios which are: Expected, Adverse, and Severe Adverse;
3. Earnings for each of the three scenarios are estimated, and
4. Capital at Risk and end-of-test capital ratios are presented for each scenario.
If you are interested in a forward-looking stress test or would like some assistance in building a Risk Appetite statement with Capital at Risk key risk indicators, please contact us.
Bert Knotts, Partner, SRA Bank – firstname.lastname@example.org (703) 581-9623
Bert is a Founding Partner of SRA with 30 plus years of banking, commercial lending, loan workout, and regulatory experience. He leads the firm’s credit risk management practice and specializes in loan generation strategies, credit risk management, and credit due diligence.