In the wake of the 2008 financial crash, it was evident that processes in the banking industry were not adequate. The banks were unable to support themselves without the help of factors beyond their control, when these faltered, so did the banks. To monitor the ability of the industry to protect itself during adverse economic situations, the Comprehensive Capital Analysis and Review (CCAR) test was introduced in 2011, with the aim of keeping banks within a sustainable model of operation, and thus protecting the wider society from the grossly negative impact similar to what the 2008 financial crash caused.

The CCAR is composed of several stress tests, designed to work out if the bank has enough capital to protect itself from negative economic developments such as a recession or a financial market crisis. In the United States, if a bank has more than $50 billion in assets, they will have to complete stress tests through both their own risk management teams as well as a test by the Federal Reserve.

What is a bank stress test?

To determine a bank’s ability to protect itself in crisis situations, stress tests concentrate on the following key areas:

  • Credit risk
  • Market risk
  • Liquidity risk

Computer simulations are used to run hypothetical models of crisis events based on criteria set by the Federal Reserve and International Monetary Fund. In this process, all banks are stress tested with a common set of ‘base’ ‘adverse’ ‘severely adverse’ scenarios. One of these hypothetical models might involve a natural disaster in South America, political instability in Northern Africa or anywhere else. Other scenarios involve social factors such as a 17% drop in house prices and a 12% unemployment rate, amongst a range of others.

Beyond the above speculative scenarios, the tests also replicate crises that have taken place in the past such as:

  • The Great Depression
  • The 1999 – 2000 Tech Bubble Bust
  • The 2007 Financial Crisis

With these scenarios laid out, the banks then compile their financial predictions for the next nine quarters and analyze if they have enough capital in the business to survive all eventualities. Each year, the CCAR changes slightly with different models simulated.

What is the impact of Stress Tests and CCAR on banks?

The CCAR and results of the stress tests are published and publicly viewable, which is required by law. This means everyone is able to view how a bank would perform under the scenarios tested.

Under CCAR, organizations that cannot withstand the stresses of the hypothetical scenarios must respond by reducing the dividends they payout, as well as share buybacks. The aim of these strategies is to protect and build back up the bank’s capital reserves. Banks that do not meet the required levels to pass have to deal with public scrutiny. In the past this has impacted share prices.

It’s not just a straight pass or fail for the financial institutions, from time to time banks are given conditional passes. Essentially, the bank almost failed the tests. In this case, the organization in question will have to resubmit a plan of action that rectifies the identified risk.

It’s hard to argue against the importance of CCAR in the regulation of banks. The impact of these institutions collapsing has wide ramifications for society well beyond the economic sector. Because of this, ensuring there are responsible practices in place that prevent the actions which led up to the 2007 crash are vital to continually monitor and improve upon.

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