CCAR Stress Testing Basics - Moody's Analytics

CCAR Stress Testing Basics By: Michael Fadil

October 17, 2012

Chicago

Risk Practitioner Conference - 2012

2 RPC 2012 – Stress Testing Basics

Stress Testing – What is It??

Can mean many things. . .

“Stress testing is a useful method for determining how a portfolio will fare during a period of financial crisis”

www.investopedia.com


Generically, “Stress Testing” is Very Broad • Can be applied to various risk types

– Credit – Market – Liquidity

• Can be applied at many levels – Counterparty / Borrower – Portfolio – Enterprise

• Can be static or dynamic – Static – only changing one variable (sensitivity analysis) – Dynamic – model a scenario with inter-relationship across variables

• Methodology – Top Down vs Bottoms Up

• Results can be expressed differently – Risk based (EL, EC, VaR . . .) – Accounting based (Net Income, Regulatory Capital Ratios)


CCAR and Stress Testing • CCAR = “Comprehensive Capital Adequacy Review”

– All banks > $50B in assets – Regulator driven

• History – SCAP (Supervisory Capital Adequacy Program) : Q1 / Q2 2009 – CCAR I : Nov 2010 – Feb 2011 – CCAR II: Nov 2011 – Feb 2012 – Fed NPR Dec 20, 2011 / Jan 5, 2012 Federal Register – FDIC NPR Jan 23, 2012 Federal Register – Fed and FDIC NPRs are highly “harmonized” – $10 - $50B Banks have until fall of 2013 when required to “participate”

• Most bank ICAAPs are converging with CCAR framework • I will use “stress test” to be synonymous with “CCAR”

Require semi-annual submissions


NPR Requirements for Stress Testing • Minimum of 3 economic scenarios

– Baseline – Adverse – Severely Adverse

• Output (for each scenario, quarterly) – Pro forma Capital positions (Tier 1 Common and Tier 1) – Estimated “Losses” (Charge-offs) by exposure category – Pre-Provision Net Revenues (PPNR) – Aggregate Loan Balances – Total Assets and RWA – Allowance for Loan Losses – Potential Capital Actions

• Timeframe - 9 quarters • Submissions

– Annual CCAR (November – January, public disclosure early April) – Submission of additional stress test (July, public disclosure Oct)








Economic Scenarios • Requirements

– A scenario must be consistent across all economic drivers – Need to augment Fed scenarios with additional economic inputs – Scenarios should be important to each bank’s specific risks

• Decision – Internally derived or use a third party? • Internal

– Resource considerations – Expertise

• Most banks are landing on outsourcing – Moody’s Economic and Consumer Credit Analytics (ECCA)

• Wide number of “off the shelf” scenarios – ECCA generates a full scenario aligned with the Fed adverse – ECCA framework allows clients to create their own scenarios – Moody’s economists will work with clients on customizations – Banks and Regulators like probabilities associates with scenarios








Decomposing Capital Ratios • Capital Ratios (Common and Total Tier 1)

– Numerator is Core Capital – Denominator is RWA

• Core Capital – Tier 1 Common Equity

» Retained Earnings » Common Stock

– Total Tier 1 Capital » Tier 1 Common Equity, plus » Certain Preferred Shares » Certain Non-Controlling Interests

• RWA – Still Basel 1 RWA – Eventually will be Basel 2 / 3 RWA

Capital Actions

Net Income PPNR

Total Assets

Loan Balances

∆ ALLL

Charge-offs (Losses)

Expenses

Revenues








Losses • Estimated “Losses” by exposure category • Losses for CCAR Stress Testing are NCOs, not EL • The two can be materially different

PD = 2.00% 30% qtr 1LGD = 50% LGD timing = 70% year 1 15% qtr 2

EL = 1.00% 25% year 2 15% qtr 35% year 3 10% qtr 4

--------------------- ------------------- --------------------------------------------------------------------

Defaults Q1 Q2 Q3 Q4 YearQ1 0.50% 0.08% 0.04% 0.04% 0.03% 0.18%Q2 0.50% 0.08% 0.04% 0.04% 0.15%Q3 0.50% 0.08% 0.04% 0.11%Q4 0.50% 0.08% 0.08%

Total = 2.00% 0.08% 0.11% 0.15% 0.18% 0.51% vs EL = 1.00%

Q1 Default Cohort, Q1 NCOs

NCO ~ (PD / 4) * (LGD * Q1 LGD NCO)NCO ~ (2.00% / 4) * (50% * 30%)NCO ~ (0.50%) * (15%)NCO ~ 0.075 ~ 0.08%

NCOs

Assumptions

For the geeks in the group


Loss Forecasting Solutions • Retail / Consumer

– Top down » Credit Cycle

– Bottoms up » Mortgage Portfolio Analyzer » Credit Card Portfolio Analyzer » Auto Portfolio Analyzer

• Wholesale / Commercial – Top down

» Commercial Loan transition matrices – Bottoms up

» RiskCalc » Credit Monitor » LossCalc








PPNR / Loan Balances • Pre-Provision = ALLL changes are excluded here • Revenues and expenses must align to loss scenario • Revenue Forecast

– Net Interest Income » Loans

– Balances – Fixed / Floating Mix – Terms – Riskiness

» Funding mix » Yield curve

– Fee Income • Expense Forecast

– Generally derived from activity based costing – Need to acknowledge semi-fixed nature of many costs

• Generally least sophisticated of banks “models”








Total Assets / RWA

• Loan balances will be primary driver for total assets

• Straight-forward application of Basel 1 RW to various asset classes and loan types

• RWA – Currently requires only Basel 1 – Additional Basel RWA calculations will happen

• Banks are implementing regulatory capital engines – Thinking ahead of integration into CCAR stress testing








Change in Loan Losses Reserves • Change in ALLL • Accounting treatment for ALLL is in flux • Most banks ALLL is not 100% formulaic

– Must treat it as such for this exercise

• Challenge for adverse and severely adverse scenarios – Banks can look at ALLL as coverage of future losses – ALLL will not be a function of perfect foresight regarding NCOs – ALLL at any future point will be conditional

» Adverse scenario to that point of analysis » Thereafter, expected baseline given the economic path to that point

• Change in reserves can be a material earnings lever – Since earnings affect capital, ALLL changes are material – Increasing scrutiny from Regulators in process

= Provision = Impact on Net Income








Capital Actions

• Dividends

• Dividend changes

• Capital issuances

• Capital repurchases

• High level views regarding acquisitions and divestitures

• Mostly discretionary actions of bank but with constraints


Visualization of Integrated Stress Test

Capital Plan


Other Important Considerations • Data, data, and more data • Documentation

– Component models – especially weaknesses – Capital Plan

• Formal governance • Executive level communication and interaction

– Executive Management – Board of Directors


Conclusions • CCAR is huge • Enterprise-wide challenge

– Treasury – Risk – Finance – LOBs

• Banks > $50B are generally in pretty good shape • Banks between $10B and $50B are in various states of preparedness • Few “off the shelf” / integrated solutions • CCAR will continue to evolve

– dividends and other capital actions


Moody’s Analytics Stress Testing Product Offering By Asset Class WHOLESALE LENDING RETAIL LENDING DEBT

Commercial & Industrial Domestic

Commercial Real Estate

Domestic Residential Retail Other Retail Lending

Structured Finance

Debt Securities Bonds

DATA, MODELING & SOFTWARE SOLUTIONS

USAGE Large Public

Large Private

Small-Med Size Privately

Held

First Lien, HELOC,

HELOANS

Credit Cards

Auto Loans

Bus-iness

Consumer & Student

Loan Portfolios

Int’l Retail Loan

Portfolio

Corporate & Financial Municipal Sovereign

DA

TA (H

isto

rical

& L

oan

Leve

l)

Public Firm Historical EDF Data: PD

Default Recovery Database (DRD) PD, LGD

Credit Research Database (CRD): PD, EAD

Structured Finance (Loan By Loan, non-corporate) PD, LGD

Case-Shiller Indices: historical, projected & aggregated PD, LGD

Structured Finance Performance Data Service (PDS) PD, LGD

Default Pre-Payment Loss Curve (DPLC): securitized assets only, projected & aggregated data PD, LGD

Credit Forecast.com: historical, projected & aggregated PD, LGD

Structured Finance Default & Recovery Service (SFDRS) PD, LGD

Moody’s Financial Metrics: historical, projected & loan level EL

Market Implied Ratings (MIR): same as above EL

Municipal Financial Ratio Analysis (MFRA) EL

Fiscal Space: historical, projected, aggregated & loan level PD, LGD

MO

DEL

ING

(Loa

n Le

vel)

Credit Cycle: Custom, Aggregated Level Model PD, LGD, EAD

CreditEdge Plus (Stressed EDFs) PD

LossCalc: Custom Model LGD

RiskCalc: Custom Model PD

Credit Transition Matrix (CTM): Ratings Based EL

Commercial Mortgage Metrics (CMM) PD, LGD

CreditForecast.com (Generic Model) – Aggregate level PD, LGD, EAD

Mortgage Portfolio Analyzer (MPA & MPA, UK) PD, LGD

Credit Card Portfolio Analyzer (CCPA) PD, LGD

Auto Portfolio Analyzer (APA) PD, LGD

Wall Street Analytics Platform PD, LGD

CDORom PD, LGD

CDOEdge: Ratings based PD, LGD

Moody’s Financial Metrics Scorecards (FM Scorecards): Ratings Based EL

QRATE - Ratings based EL

PLA

T-FO

RM

CREDIT CYCLE: Web-based platform that houses and aggregates stress testing models and analytics

SCENARIO ANALYZER: Integrated software solution that consolidates enterprise-wide stress testing data, modeling results, capital requirements and regulatory reporting

Definitions: PD: Probability of Default; LGD: Loss Given Default; EL: Expected Loss; EAD: Expected At Default

Note: Custom solutions available across all asset classes


© 2010 Moody’s Analytics, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved. ALL INFORMATION CONTAINED HEREIN IS PROTECTED BY COPYRIGHT LAW AND NONE OF SUCH INFORMATION MAY BE COPIED OR OTHERWISE REPRODUCED, REPACKAGED, FURTHER TRANSMITTED, TRANSFERRED, DISSEMINATED, REDISTRIBUTED OR RESOLD, OR STORED FOR SUBSEQUENT USE FOR ANY SUCH PURPOSE, IN WHOLE OR IN PART, IN ANY FORM OR MANNER OR BY ANY MEANS WHATSOEVER, BY ANY PERSON WITHOUT MOODY’S PRIOR WRITTEN CONSENT. All information contained herein is obtained by MOODY’S from sources believed by it to be accurate and reliable. Because of the possibility of human or mechanical error as well as other factors, however, all information contained herein is provided “AS IS” without warranty of any kind. Under no circumstances shall MOODY’S have any liability to any person or entity for (a) any loss or damage in whole or in part caused by, resulting from, or relating to, any error (negligent or otherwise) or other circumstance or contingency within or outside the control of MOODY’S or any of its directors, officers, employees or agents in connection with the procurement, collection, compilation, analysis, interpretation, communication, publication or delivery of any such information, or (b) any direct, indirect, special, consequential, compensatory or incidental damages whatsoever (including without limitation, lost profits), even if MOODY’S is advised in advance of the possibility of such damages, resulting from the use of or inability to use, any such information. The credit ratings, financial reporting analysis, projections, and other observations, if any, constituting part of the information contained herein are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. NO WARRANTY, EXPRESS OR IMPLIED, AS TO THE ACCURACY, TIMELINESS, COMPLETENESS, MERCHANTABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE OF ANY SUCH RATING OR OTHER OPINION OR INFORMATION IS GIVEN OR MADE BY MOODY’S IN ANY FORM OR MANNER WHATSOEVER. Each rating or other opinion must be weighed solely as one factor in any investment decision made by or on behalf of any user of the information contained herein, and each such user must accordingly make its own study and evaluation of each security and of each issuer and guarantor of, and each provider of credit support for, each security that it may consider purchasing, holding, or selling.

Documents

CCAR Stress Testing Basics - Moody's Analytics