What Community Banks Should Learn from the Fed’s CCAR 2015 Scenarios

By Adam Mustafa

Last month, the Federal Reserve released the macroeconomic scenarios for banks with more than $50 billion in assets that are required to submit capital stress tests under the Comprehensive Capital Analysis and Review (CCAR) program.  Each year, the Fed adds a unique twist to these scenarios, a twist which can provide insights into regulatory priorities for all banks.  Although stress testing is not required for community banks, smart banks should understand what regulators are thinking, and use that knowledge to get ahead of both their competitors and examiners. 

Here are a few key takeaways from the CCAR 2015 scenarios that community banks should follow:

Regulators are worried again about a bubble forming in both residential real estate and CRE prices.  The declines they have simulated in the “Severely Adverse” case scenario are steeper than when the CCAR program began.

In many markets, real estate prices have fully recovered from the financial crisis of 2008 and, in some places, CRE prices have soared well above their all-time highs. We’ve heard of multi-family deals taking place in New York City at cap rates around 3 percent.  Perhaps regulators have a reason to be concerned, especially as interest rates rise.  The bottom line is that community banks should be prepared to demonstrate how their CRE portfolio will perform under a multitude of scenarios.

A loan review approach will not cut it.  While loan review—the categorization of loans into appropriate classifications, ALLL analysis, and the documentation review—is important, it is not a stress test.  Similar to traditional balance sheet or call report analysis, loan review is based on historical and current environments. Stress testing is the only forward-looking way to evaluate the performance of loans in different economic environments and determine their impact on capital adequacy.

Regulators have introduced the new interest rate risk test – and it includes a mini-recession. This is the jaw-dropper this year, although the Fed did hint this was coming in the last two CCAR stress tests.  While the regulatory focus with the CCAR banks has been – and will continue to be – the Severely Adverse Case scenario, the milder Adverse Case scenario now includes a massive increase in both short-term and long-term interest rates, a flattening yield curve, as well as rising inflation.

Banks have been telling regulators for a while that they will benefit when interest rates return to normal, assuming they will just make more loans at the higher interest rates and higher spreads.  While this is probably true for the largest banks because they have the sophistication and the hedging strategies in place, many community banks continue to take false comfort in their asset/liability models.

Regulators didn’t have the data to push back against the ALM models, but they have found an alternative solution:  Have the banks perform interest rate risk assessments in the face of a modest economic recession.  This has many ramifications.  First, it will limit, if not eliminate, the offset of making new loans at higher interest rates.  Second, the increase in debt service for many floating rate loans will lead to spikes in defaults since borrowers’ cash flows would be squeezed on both ends.  Finally, the bloodshed that would take place in investment portfolios and liability structures would be crippling to some banks.

The Fed may also be using this information to do its own strategic planning here as well. Remember, the situation they are in is unprecedented, and it will be difficult for them to manage an increase in interest rates with an improving economy,  while both inflation and deflation remain non-issues.  

Will this scenario be required for community banks?  Probably not.  But if you were a director sitting on a community bank board, wouldn’t you want to know how your bank would handle this scenario?  Could you think of a better risk management analysis given the current  economic climate?  Is there a more practical “worst case” scenario that banks are facing today?

Although they don’t say it, the Adverse Case scenario is also a disguised liquidity stress test. Check out this quote from the Fed’s instructions for 2015:  “…firms should interpret the rise in short-term interest rates embodied in this year’s adverse scenario as crystallizing certain risks to banks’ funding costs. In particular, commercial deposits should be viewed as being unusually drawn to institutional money funds, which re-price promptly in response to changes in short-term Treasury rates.”

In other words, regulators want to see how you will handle some form of disintermediation in your deposits in the face of a moderate recession.  Although many community banks have taken steps forward in terms of collecting better data on their loans, most are sorely behind on the deposit side.  Banks should be able to segment their deposits in much greater detail than they are currently doing.  Only then will they be able to understand their risks on this front, as CCAR 2015 virtually requires this from the big banks.

To sum it up: The lessons that community banks can learn from the CCAR 2015 stress scenarios are not about scare tactics, regulatory requirements coming down the pike, or best practices in enterprise risk management.  Your regulator may never even broach these topics with you.  This is about reading between the lines and positioning your bank to take advantage of these scenarios, so that if they do occur, you can take market share from your weaker competitors.