SIFMA to publish study evaluating areas of improvement, suggested alternatives

• The CCAR approach to the trading book remains largely unchanged despite nearly nine years of rulemaking which have significantly reduced the risk profile of the largest financial institutions.
• Known critical flaws of the CCAR approach to the trading booking include double counting the impact of identical positions in the overall results and an unsupportable level of conservatism baked into the calibration of the instantaneous shock.
• Despite the 2013 Policy Statement on Scenario Design Framework for Stress Testing, which stated that the severely adverse scenario would largely “reflect conditions that characterize post-war U.S. recessions” the 2019 scenario was significantly more severe.
• Revisions to the CCAR approach for the trading book are long overdue and need to address the shortfalls in the current framework.

Today – May 7 – marks a decade since the announcement of the results of the Supervisory Capital Assessment Process (SCAP), the precursor to the Comprehensive Capital Assessment Review, (CCAR).  There is no debate SCAP successfully restored confidence in the U.S. banking system; and moreover, prompted 10 of the 19 initial participants to raise over $75 billion of new capital. It also ushered in the use of capital stress testing as a new supervisory tool, if not the primary supervisory tool.

A decade later, the current CCAR framework largely reflects the decisions made during the rapid development of SCAP, when supervisors did not have the luxury of time to study or debate alternatives. In no other area of the CCAR process is this more evident than in the treatment of trading book assets.

Despite millions of pages of new rules and guidance including sweeping changes to the Basel Committee’s global accord which have drastically changed the risk profile of the trading book, there has been almost no change to the supervisory approach for these asset types.

Since 2010, regulators have rolled out new requirements around liquidity, swaps clearing, central counterparties, recovery and resolution, securitizations, proprietary trading and covered funds, just to name a few, which have radically altered the types of products, business lines and strategies a firm could pursue as well as its overall financial risk profile. To illustrate the extent by which balance sheets were permanently altered, consider CET1 for CCAR firms grew 72% between 2009 and 2017. The same group of banks also operated at 510 bp above the Basel minimums for CET1 and 260 bp above maximum regulatory capital requirements inclusive of G-SIB surcharges. Similarly, liquidity as defined as cash + interbank placement /total assets reached 15.4% at the end of 2017 versus 3.7% at in the first quarter of 2007 for GSIBs and reached 13.7% versus 3.9% during the same period for the CCAR banks. Nonetheless, the CCAR trading book treatment remains locked in 2009.

Some suggest that there is little supervisory interest in revising the trading book treatment as it is based on wildly conservative assumptions. For example, the macroeconomic scenarios used for the 2019 stress test were significantly more stringent than the experience during the “Great Recession” and any other post-war recession. Moreover, the Global Market Shock framework relies on an instantaneous hit to trading book positions without consideration for recoveries, portfolio recalibration or hedging.  Additionally, a firm which is required to apply the GMS is also required to project trading losses on the same trading book over the nine-quarter period resulting in a double-counting of loss impact.

The Federal Reserve has made some annual attempts to work with the industry and academics to improve and expand on scenario development and modeling, to refine stress testing approaches for different asset classes and forecasting PPNR and balance sheet assets. However, little of the discussion has resulted in any real movement from the ordained path set back in 2009. There has even been less progress in studying the approaches to the trading book.

Given recent comments by Federal Reserve Officials as well as the commitments made in response to the GAO report on stress testing published in 2016, it is the right time for the Federal Reserve to engage impacted banks, industry groups, other stakeholders and a broad representation of academia in an open and active dialogue regarding the CCAR approach to trading book.

In the effort to begin this dialogue, SIFMA with some of its members has initiated our own evaluation of CCAR’s current treatment of the trading book with the objective of identifying areas for suited for enhancements given the shortfalls of current approaches. Moreover, our study will offer some rationale alternatives which are supportive of the supervisory goal of stress testing. Our study will be available in late June.

Joseph L. Seidel is Chief Operating Officer at SIFMA. He manages day-to-day operations of the Association, including core legal, regulatory, business practices, public policy and communication activities.

For additional information on this topic please contact Carter McDowell, Managing Director, Associate General Counsel at SIFMA, at [email protected].