Federal Reserve: Additional Actions Could Help Ensure the Achievement of Stress Test Goals
Highlights
What GAO Found
The Board of Governors of the Federal Reserve System (Federal Reserve) has two related supervisory programs that involve stress testing but serve different purposes. Stress tests are hypothetical exercises that assess the potential impact of economic, financial, or other scenarios on the financial performance of a company. Stress tests of banking institutions typically evaluate if the institutions have sufficient capital to remain solvent under stressful economic conditions.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) implements statutory stress test requirements, known as the Dodd-Frank Act Stress Tests (DFAST) for Federal Reserve-supervised banking institutions with more than $10 billion in total consolidated assets. DFAST projects how banking institutions' capital levels would fare in hypothetical stressful economic and financial scenarios. It applies to a broad range of banking institutions and consists of supervisory- and company-run stress tests that produce capital adequacy information for firms' internal use and for public disclosure.
The Federal Reserve also conducts a Comprehensive Capital Analysis and Review (CCAR), which uses DFAST information to assess the capital adequacy (a quantitative assessment) and capital planning processes (a qualitative assessment) for bank holding companies with total consolidated assets of $50 billion or more. CCAR generally does not require additional stress tests and uses the same data, models, and projections used for DFAST.
While the primary purpose of DFAST is to produce and disclose comparable information on the financial condition of banking institutions (the stress test results), the Federal Reserve uses CCAR to make supervisory assessments and decisions about the capital adequacy plans (including proposed capital actions such as dividend payments) of large bank holding companies. For example, the Federal Reserve may object to a company's plan if stress test results show the company's post-stress capital ratios (regulatory measures that indicate how much capital is available to cover unexpected losses) falling below required minimum levels or if the Federal Reserve's qualitative assessment deems the firm's capital planning and related processes inadequate. An objection can result in restrictions on a firm's capital distributions. Several of the companies GAO interviewed that are subject to Federal Reserve stress tests identified benefits from the tests (such as overall improvements in risk management and capital planning) and also identified costs (including for staff resources and other expenditures necessary to conduct the tests and meet the Federal Reserve's supervisory expectations).
GAO found limitations in the Federal Reserve's stress test programs that could hinder their effectiveness.
Qualitative assessment disclosure and communication. The Federal Reserve uses a framework with multiple levels of review to assess qualitative CCAR submissions that helps ensure consistency, but it has not disclosed information needed to fully understand its assessment approach or the reasons for decisions to object to a company's capital plan. Transparency is a key feature of accountability and such incomplete disclosure may limit understanding of the CCAR assessments and hinder public and market confidence in the program and the extent to which the Federal Reserve can be held accountable for its decisions. Federal internal control standards state the importance of relevant and timely communications with external stakeholders. The Federal Reserve has not regularly updated guidance to firms about supervisory expectations and peer practices related to the qualitative assessment. For example, it has not published observations of leading capital planning practices used in CCAR since 2014. The limited communication can pose challenges to companies that must meet these expectations annually and could hinder the achievement of CCAR goals.
Scenario design. The Federal Reserve has a framework for designing stress test scenarios but its analysis of some key design decisions has been limited. For example, the Federal Reserve has not conducted analyses to determine whether the single severe scenario it uses for the supervisory stress test is sufficient to accomplish DFAST and CCAR goals. While there are advantages to using one scenario—including simplicity and transparency—many different types of financial crises are possible, and the single selected scenario does not reflect a fuller range of possible outcomes. Without additional analysis, the Federal Reserve cannot be reasonably assured that banks are resilient against a range of future risks. The Federal Reserve also has not explicitly analyzed how to balance the choice of severity—and its influence on the resiliency of the banking system—with any impact on the cost and availability of credit, which could limit its ability to avoid undesired economic effects from scenario design choices.
Model risk management. Federal Reserve supervisory guidance for banking institutions states that risk from individual models and also from the aggregate system of models should be managed. The Federal Reserve makes supervisory decisions based on the results of its own stress test models, but its management of model risk—the potential for adverse consequences from decisions based on incorrect or misused model outputs—has not focused on its system of models that produce stress test results. To estimate the effect of stress test scenarios on companies' ability to maintain capital, the Federal Reserve has developed individual component models that predict a company's financial performance in the scenarios. The results of these component models are combined with assumed or planned capital actions of companies and form the system of models used by the Federal Reserve. The Federal Reserve has an oversight structure for developing and using models in the supervisory stress tests but its own risk-management efforts have not targeted the system of models. For example, it has not conducted sensitivity and uncertainty analyses—important elements in the Federal Reserve's model risk management guidance—of how its modeling decisions affected overall results. Without such a focus, the Federal Reserve's ability to effectively evaluate and manage model risk and uncertainty from the entire system of stress test models will be limited. Understanding and communicating this uncertainty is critical because the outcome of the CCAR assessment can have significant implications for a company, including limiting its capital actions (such as dividend payments and share repurchases).
Why GAO Did This Study
The Federal Reserve has two stress test programs for certain banking institutions it supervises. DFAST encompasses stress tests required by the Dodd-Frank Act. CCAR comprises a qualitative assessment of firms' capital planning processes and a quantitative assessment of firms' ability to maintain sufficient capital to continue operations under stress. Questions have been raised about the effectiveness and burden of requiring two stress test programs. GAO was asked to review these programs and their effectiveness. This report examines how the stress test programs compare, the CCAR qualitative assessment, and the design of the stress test scenarios and models.
GAO analyzed Federal Reserve documents including rules, guidance, and internal policies and procedures on DFAST and CCAR implementation and assessed practices against federal internal control standards and other criteria. GAO also interviewed Federal Reserve staff and officials of 19 banking institutions selected based on characteristics such as their size, prior stress test participation, and history of CCAR results.
Recommendations
GAO is making 15 recommendations to help improve the effectiveness of the Federal Reserve's stress test programs, such as improving disclosures and communications to firms, considering the potential consequences of its scenario design choices, and expanding model risk management to include the entire system of models. The Federal Reserve generally agreed with the recommendations and highlighted select ongoing and future efforts.
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Office of the Comptroller of the Currency | To help improve the consistency of federal banking regulators' stress test requirements and help ensure that institutions overseen by different regulators receive consistent regulatory treatment, the heads of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency should harmonize their agencies' approach to granting extensions and exemptions from stress test requirements. |
According to FDIC, Federal Reserve, and OCC staff, the agencies have agreed to meet annually to coordinate planned exemptions and extensions of stress test requirements prior to agency action. The agencies held the first annual meeting in January 2017 to review the extensions and exemptions from stress testing requirements.
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| Federal Deposit Insurance Corporation | To help improve the consistency of federal banking regulators' stress test requirements and help ensure that institutions overseen by different regulators receive consistent regulatory treatment, the heads of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency should harmonize their agencies' approach to granting extensions and exemptions from stress test requirements. |
According to FDIC, Federal Reserve, and OCC staff, the agencies have committed to meeting at least annually to coordinate planned exemptions and extensions of stress test requirements prior to agency action. In January 2017, the agencies held a first annual meeting to review extension and exemption requests. In addition, in December 2016, staff participated in an interagency coordination meeting to discuss a firm-specific exemption request.
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| Federal Reserve System | To help improve the consistency of federal banking regulators' stress test requirements and help ensure that institutions overseen by different regulators receive consistent regulatory treatment, the heads of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency should harmonize their agencies' approach to granting extensions and exemptions from stress test requirements. |
According to FDIC, Federal Reserve, and OCC staff, the agencies have established a process to meet at least annually to coordinate planned extensions and exemptions from stress test requirements prior to agency action. In January 2017, the agencies held a first annual meeting to review extension and exemption requests. In addition, in December 2016, staff participated in an interagency coordination meeting to discuss a firm-specific exemption request.
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| Federal Reserve System | To help provide stronger incentives for companies to perform company-run stress tests in a manner consistent with Federal Reserve goals, the Federal Reserve should remove company-run stress tests from the CCAR quantitative assessment. |
In March 2020, the Federal Reserve finalized amendments to its capital requirements and stress test rules. Among other changes, the amendments remove the quantitative objection in CCAR and replace it with a stress capital buffer based on supervisory stress test results and not on the results of company-run stress tests. This change aligns the use of the company-run stress test with the Federal Reserve's supervision of capital planning practices by using the company-run tests to evaluate how a firm develops its own stress scenarios to reflect its idiosyncratic risks. As a result, the final rule amendments should provide stronger incentives for firms to perform company-run stress tests in a manner consistent with Federal Reserve goals.
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| Federal Reserve System | To increase transparency and improve CCAR effectiveness, the Federal Reserve should publicly disclose additional information that would allow for a better understanding of the methodology for completing qualitative assessments, such as the role of ratings and rankings and the extent to which they affect final determination decisions. |
In June 2017, the Federal Reserve publicly released its stress test assessment framework and results report. The 2017 report significantly expands the disclosure of information about the qualitative assessment methodology compared to earlier reports. For example, the 2017 report describes the role of ratings and rankings in the assessment framework including in relation to final determination decisions. The report also discusses the use of supervisory and horizontal evaluation teams to help assess firms' capital plan submissions and the role of senior staff committees in the decision-making process.
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| Federal Reserve System | To increase transparency and improve CCAR effectiveness, the Federal Reserve should, for future determinations to object or conditionally not object to a company's capital plan on qualitative grounds, disclose additional information about the reasons for the determinations. |
In June 2017, the Federal Reserve publicly released its stress test assessment framework and results report. The 2017 report disclosed the Federal Reserve's decision to conditionally not object to one company's capital plan on qualitative grounds. The report disclosed more specific information about the Federal Reserve's reasons for the determination. For example, in addition to describing the capital planning areas in which deficiencies were found, the report disclosed information about the nature of the deficiencies in capital planning areas leading to its determination. Specifically, the report noted that the firm's capital plan did not appropriately take into account the potential impact of the risks in one of its most material businesses and that the firm's internal control functions, including independent risk management, did not identify these material weaknesses in the firm's capital planning practices.
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| Federal Reserve System | To increase transparency and improve CCAR effectiveness, the Federal Reserve should publicly disclose, on a periodic basis, information on capital planning practices observed during CCAR qualitative assessments, including practices the Federal Reserve considers stronger or leading practices. |
As of February 2020, the Federal Reserve had not disclosed new information on the current range of capital planning practices. However, in March 2019, the Federal Reserve amended its Capital Plan Rule to remove the qualitative assessment from CCAR (certain institutions may remain subject to the qualitative assessment under transitional arrangements). Federal Reserve staff stated that the Federal Reserve will instead focus on evaluating firms' capital planning practices through its regular supervisory process, including its examination program. With these changes to eliminate the CCAR qualitative assessment, our recommendation is no longer applicable. Because our recommendation was intended to improve rather than eliminate the CCAR qualitative assessment, we are closing this recommendation as unimplemented.
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| Federal Reserve System | To increase transparency and improve CCAR effectiveness, the Federal Reserve should improve policies for official responses to CCAR companies by establishing procedures for notifying companies about time frames relating to Federal Reserve responses to company inquiries. |
In August 2017, the Federal Reserve implemented revised procedures for responding to inquiries received from companies through its CCAR communications mailbox. The changes include sending a confirmation email to companies submitting questions that acknowledges receipt and provides an expected timeline for a response.
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| Federal Reserve System |
Priority Rec.
To strengthen the scenario design process, the Federal Reserve should assess--and adjust as necessary--the overall level of severity of its severely adverse scenario by establishing a process to facilitate proactive consideration of levels of severity that may fall outside U.S. postwar historical experience. |
In February 2019, the Federal Reserve finalized amendments to its scenario design framework that, among other changes, established a process to annually assess and consider the inclusion of salient risks in the severely adverse scenario. The annual assessment will facilitate proactive consideration of scenario severity levels that fall outside U.S. postwar historical experience.
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| Federal Reserve System |
Priority Rec.
To strengthen the scenario design process, the Federal Reserve should assess--and adjust as necessary--the overall level of severity of its severely adverse scenario by expanding consideration of the trade-offs associated with different degrees of severity. |
In 2020, the Federal Reserve completed two projects that allow a more efficient evaluation of multiple scenarios and assess trade-offs associated with different levels of scenario severity. Since the 2018 stress test cycle, the Federal Reserve also has used several internally developed methods and metrics to assess the severity of scenarios during the scenario design process, including on key indicators of bank financial conditions. These steps enhance the Federal Reserve's assessment of important trade-offs associated with scenario severity and could be leveraged to ensure that the scenario design process balances any improvements in the resiliency of the banking system with any impact on the cost and availability of credit.
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| Federal Reserve System |
Priority Rec.
To improve understanding of the range of potential crises against which the banking system would be resilient and the outcomes that might result from different scenarios, the Federal Reserve should assess whether a single severe supervisory scenario is sufficient to inform CCAR decisions and promote the resilience of the banking system. Such an assessment could include conducting sensitivity analysis involving multiple severe supervisory scenarios--potentially using CCAR data for a cycle that is already complete, to avoid concerns about tailoring the scenario to achieve a particular outcome. |
In 2020, the Federal Reserve completed two projects that allow a more efficient evaluation of multiple scenarios and assess trade-offs associated with the use of multiple scenarios. In the 2020 stress test cycle, the Federal Reserve used its internally developed methods and metrics to assess the severity of multiple scenario options and disclosed the aggregate results of sensitivity analyses conducted under additional severe scenarios related to possible economic ramifications of COVID-19.
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| Federal Reserve System | To help ensure that Federal Reserve stress tests do not amplify future economic cycles, the Federal Reserve should develop a process to test its proposed severely adverse scenario for procyclicality annually before finalizing and publicly releasing the supervisory scenarios. |
On February 5, 2019, the Federal Reserve finalized amendments to its Policy Statement on Scenario Design intended to make the unemployment rates and house prices used in its scenarios more predictable and less procyclical. The adjustments to the way these variables are set in the scenario address key potential drivers of procyclicality.
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| Federal Reserve System |
Priority Rec.
To improve the Federal Reserve's ability to manage model risk and ensure that decisions based on supervisory stress test results are informed by an understanding of model risk, the Federal Reserve should apply its model development principles to the combined system of models used in the supervisory stress tests. |
Beginning in 2017, the Federal Reserve has taken steps to address the incorporation of a combined system of models into execution of its supervisory stress tests, including amending guiding principles and policies governing supervisory stress test model development. The Federal Reserve also has developed model-system documentation and incorporated a combined model-system approach in applying its principles for designing, developing, and implementing stress-test models. These actions improve the Federal Reserve's ability to manage overall model risk and understand its effects on stress test results.
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| Federal Reserve System |
Priority Rec.
To improve the Federal Reserve's ability to manage model risk and ensure that decisions based on supervisory stress test results are informed by an understanding of model risk, the Federal Reserve should create an appropriate set of system-level model documentation, including an overview of how component models interact and key assumptions made in the design of model interactions. |
In 2019, the Federal Reserve finalized model-system documentation that describes the purpose, theory, design, and implementation of the model system used in the supervisory stress tests. The documentation includes an overview of how component models interact and key assumptions made in the design of model interactions. The new documentation will help improve the Federal Reserve's ability to manage overall model risk and understand its effects on stress test results.
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| Federal Reserve System |
Priority Rec.
To improve the Federal Reserve's ability to manage model risk and ensure that decisions based on supervisory stress test results are informed by an understanding of model risk, the Federal Reserve should design and implement a process to test and document the sensitivity and uncertainty of the model system's output--the post-stress capital ratios used to make CCAR quantitative assessment determinations--including, at a minimum, the cumulative uncertainty surrounding the capital ratios and their sensitivity to key model parameters, specifications, and assumptions from across the system of models. |
By January 2021, the Federal Reserve had completed three projects it undertook to respond to our recommendation. It also had made substantial progress on a fourth project that included implementing a comprehensive framework and process to test and document the sensitivity and uncertainty of post-stress capital ratios. The completed actions are responsive to our recommendation and enhance the Federal Reserve's ability to effectively evaluate and manage model risk and uncertainty from the entire system of stress test models.
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| Federal Reserve System |
Priority Rec.
To improve the Federal Reserve's ability to manage model risk and ensure that decisions based on supervisory stress test results are informed by an understanding of model risk, the Federal Reserve should design and implement a process to communicate information about the range and sources of uncertainty surrounding the post-stress capital ratio estimates to the Board during CCAR deliberations. |
In January 2019, the Federal Reserve said it had previously initiated a project to design and implement a process to communicate uncertainty surrounding the post-stress capital ratio estimates. In February 2022, the Federal Reserve provided information about its process to communicate model risk and uncertainty analysis results. In March 2024, the Federal Reserve finalized procedures for executing and distributing uncertainty analysis. The procedures include process steps to communicate uncertainty surrounding the post-stress capital ratio estimates to the Board. The procedures will improve the Federal Reserve's ability to effectively evaluate and manage its model risk and help ensure that the Board is informed of significant model risks when making decisions based on stress test results.
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| Federal Reserve System |
Priority Rec.
To improve the Federal Reserve's ability to manage model risk and ensure that decisions based on supervisory stress test results are informed by an understanding of model risk, the Federal Reserve should design and implement a process for the Board and senior staff to articulate tolerance levels for key risks identified through sensitivity testing and for the degree of uncertainty in the projected capital ratios. |
In January 2019, the Federal Reserve said it had previously initiated a project to respond to our recommendation. In March 2024, the Federal Reserve finalized procedures for executing and distributing analysis of uncertainty surrounding post-stress capital ratios and the levels and sources of model risks. The procedures include process steps for the Board and senior staff to articulate tolerance levels for identified risks and the degree of uncertainty in the projected capital ratios. The procedures will improve the Federal Reserve's ability to effectively evaluate and manage its model risk and help ensure that the Board is informed of significant model risks when making decisions based on stress test results.
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