The Fed released its first of two pronouncements yesterday on the health of the financial services sector. The first was the Dodd-Frank mandated Stress Test for qualifying financial institutions. The goal is to determine how resilient those organizations are to potential financial shocks.
To achieve this the Federal Reserve oversees a number of scenarios (company-run stress tests) as part of the bank’s overall CCAR submission. These tests, both qualitative and quantitative, are meant to measure the sources and uses of capital under baseline and stressed economic and financial conditions, to ensure capital adequacy in all market environments.
This is a remarkably complex problem for the banks, complexity that is further exacerbated by the size of the institution.
Zions Bank is not as complex as Citigroup for example. Any one of Citigroup’s dozen or so business units could qualify as one of the country’s largest institutions.
Consider this: each business unit of Citigroup had to evaluate how ~2,600 economic variables would impact them. Citigroup as a whole had to then integrate those results into a larger model that reflected the performance of the bank under various scenarios.
The total possible outcomes in these models stretches the bounds of human understanding. Yet the output has to be just that – understandable by humans (the regulators at the Federal Reserve).
Still, Citigroup made it happen. They reduced the complexity. They enabled the business leaders to participate actively in the process. They developed new approaches for this cycle – approaches that had never before been used in this context.
It paid off for them.
They passed the initial stage comfortably and now await the second phase which dictates their capital return flexibility (dividends or stock buybacks).
This is an annual achievement worth noting for all the institutions that are struggling with the complexity of this regulatory requirement.
We know a little about complexity and always like it when it can be distilled into insight. That’s what we like about the CCAR process. A giant problem with huge implications. Just our kind of challenge.