To begin, reflect on what DFAST tell us. It shows our capital levels over 9 quarters under three different economic scenarios that we may or may not consider plausible.
For risk tolerance example 1, let’s set minimum capital ratios or levels for each scenario and quarter. We can easily measure such a threshold, and anyone can tell whether we are within our outside our tolerance. For example, the threshold could be a total capital ratio of 10% in severe stress. If the severe stress case shows a capital ratio below 10% in any of the 9 quarters, the threshold is tripped and action must be taken.
But is that useful? What action do we take when a scenario takes us below our tolerance level? The correct response might be to raise more capital. If so, setting an appetite in this way is appropriate. That said, the scenario that trips the tolerance might be excessively severe and remote. Further, the bank might start with a large capital cushion over regulatory minimums. In that case, raising capital is not the most appropriate response. It would hurt shareholders, ironically incent more risk taking and exacerbate executive compensation. This is tantamount to managing to Armageddon. Banks that manage to Armageddon have difficulty remaining competitive.
With example 2, let’s focus on sensitivity rather than projected absolute capital ratios or balances. Here, we set a tolerance on how much we let capital ratios change from base to stress conditions. For example, the threshold could be that the total capital ratio may not fall by more than 250 basis points from the base to the severe stress scenario. The risk appetite could require analysis and recommendations if the 250 basis point threshold is tripped.
Is this approach useful? I think so because it gives management more insight into how its business lines impact capital. Perhaps there is one business line, say subterranean toxic waste lending in the Gulf, that consumes 200 of the 250 basis point drop. Management knows to look critically at the returns from that business. Conceivably, with a name like subterranean toxic waste lending in the Gulf, management wouldn’t need a DFAST related appetite tolerance to look at it critically. What about a more innocuous sounding business line like, Credit Default Desk, or Subprime mortgage securitization? The severe stress case in the 2016 DFAST scenarios would have shown both to take a considerable chunk out of total capital ratios.
What are the benefits of using stress testing results to inform the risk appetite?
By design, stress testing requires management to look at plausible worst case scenarios. Risk Appetites are normally conceived in a Business As Usual (“BAU”) circle. I recognize that setting tolerances consistent with risk appetites involves thinking about tail events. Nevertheless, few set risk appetite tolerances based on being in a prolonged stress environment. Indeed, we should not do so because the gulf between that and managing to Armageddon is not that great. So a stress test lets us look at our performance from a dystopian viewpoint. From that viewpoint, we know where we will need to portage and where we can keep on paddling. A risk appetite that allows more paddling than portaging in stress environments is more robust and will better serve a bank. A risk appetite that lets you paddle only until the next nasty turn is less useful. As I’ll elaborate at the Congress in November, stress testing, which we have to do anyway, is an effective way to tell those two risk appetites apart.
I love this question, but I was not permitted to answer it beyond what we disclose in our DFAST public disclosure, and that limitation makes my response decidedly uninteresting.
How do you see the industry progressing over the coming years, in light of recent changes and trends?
I believe in rate increases so much that folk have caught me clapping in my cubicle – don’t judge me, it worked for Tinkerbell! For those unfortunate enough not to get my allusion to Pantomime Theatre, let’s assume we continue in a low interest rate, innovation challenged, compliance burdened industry. Worse still, unregulated financial services companies and robots challenge us with increasingly competitive product offerings from payment channels to financial advice. That leaves us with lower margins and fewer customers. How can we grow?
I guess we could look on the bright side. The next dozen years will see the largest transfer of wealth from one generation to the next in the history of humans, and people still trust banks more than car dealers. Technology enables integration in ways unimaginable even 10 years ago. If we can’t beat the unregulated financial services companies and robots, maybe we can join them, joint venture with them or assimilate them.
In either event, the pickings will be slim, margins tight and regulatory standards high. A financial institution that can leverage regulatory standards can outperform one that does not, and tying stress test to risk appetite might just be one way to make that happen.