Do the CCAR (Comprehensive Capital Analysis and Review) scenarios signal regulatory focus? Put another way have preliminary indications about regulatory concern over developing CRE concentrations been subtly reinforced in this year’s stress scenarios? Some folks, particularly my family, might accuse me of probably diving a little too deep into numbers at times. I am sure it dates back to my childhood and committing to memory the batting statistics of my favorite Major League baseball players, and then naturally evolved through my high school and college years with a general comfort for the black and white of math oriented classes. In my professional career, I have always been intrigued not so much by what the numerous banking performance metrics attempt to convey with regard to relative valuations, but more so by delving deeper behind the numbers to learn what that might mean for the future. And so it is, to the chagrin of my kids, that each year I look at the Fed-generated stress scenarios for the annual CCAR and DFAST (Dodd-Frank Act Stress Test) exercises to see, if by chance, there is possibly a veiled or even overt effort to signal area(s) of pertinent focus with regard to the regulatory oversight of our banking industry.

First, let’s back up a bit to broadly recall the genesis of the CCAR exams at our nation’s largest banks, and the subsequent development of the comparable DFAST exercises for institutions in the $10 to $50 billion asset size range. During the financial crisis, regulators hoped that by implementing a program designed to assess capital adequacy and the ability of banks to continue lending in the event of severe market conditions, it might help mitigate uncertainty and restore public confidence in our nation’s financial institutions. In early 2009, U.S. banking regulators began conducting stress tests which became known as SCAP (Supervisory Capital Assessment Program) on 19 of the largest banks in the country.

Subsequent passage of Dodd-Frank required the Fed to conduct annual stress tests at the biggest banks, formalized in late 2012 when regulators unveiled new rules that effectively framed the stress testing regime and requirements for the industry’s largest players (effectively, those with consolidated assets north of $50 billion). By early 2014, these CCAR requirements in large part passed down to “mid-sized” financial institutions (consolidated assets between $10 and $50 billion) in what is simply known as the DFAST exercises. DFAST incorporated much of the framework applied to the much larger domestic and international organizations, which included the utilization of more than two dozen macroeconomic variables that broadly cover measures of economic activity, asset pricing and the relative levels of short-term and long-term interest rates.

Succinctly, these variables, where applicable, are then assessed by the banks to create hypothetical earnings and balance sheet forecasts detailed over a forward-looking nine-quarter time horizon. Resultant capital measures, and relative earnings and asset quality metrics, are then assessed to gauge the resiliency of the institution to these severe “what if” scenarios. Coming out of the recession, community banks, and those falling outside the scope of DFAST were encouraged to begin conducting portfolio stress testing as a sound risk management practice. While it is unknown at this point what, if any, regulatory relief and/or Dodd-Frank rollback might mean with regard to the application of stress tests, it seems to be generally (and genuinely) accepted that the core objectives and ensuing operating disciplines promulgated by CCAR and DFAST have been a meaningful positive for the banking industry as we have witnessed a general increase in relative capital levels across the sector. My belief is that if repealed or significantly modified, organizations will retain the stress testing systems that they have created and actively utilized because they are confident these efforts have made them safer and stronger banks. (Note: White House executive orders have sought to eliminate the laborious “qualitative” requirement of the stress test at all but Systematically Important Financial Institutions (SIFI) banks, and speculation abounds with regard to possibly raising the asset size thresholds of those legally required to conduct the tests.)

In this year’s Fed-developed CCAR scenarios, a couple of the forecasted macroeconomic variabales caught my eye:

Most notably, the Commercial Real Estate Price Index (CRE) shows a steeper and more pronounced drop in value when compared to past years. Reading the tea leaves, and noting the heightened regulatory awareness with regard to rising concentrations and pricing competition in banks’ CRE portfolios, I have to believe that this is a strong (and direct) signal to the industry that CRE will not only continue to be an area of focus for the regulators, but for those with growing or already tenuous concentration levels (i.e., approaching or beyond the stated 100 percent /300 percent guidance thresholds) it very likely will be the primary topic of discussion during regulatory exams. That is not to say that operational, credit and strategic risks will not continue to be front and center with regulators, as are growing concerns with regard to BSA/AML compliance, fintech competition and elevated cybersecurity threats. But rather, in light of preparing for the next economic downturn, banks with CRE concentrations that might otherwise cause some regulatory angst should be able to demonstrate enhanced risk management practices and a deeper, more comprehensive understanding of their borrowers.

And to underscore my belief about the potential “messaging” that occurs in generating these severely adverse stress scenarios, I also included last year’s forecast of short-term interest rates as measured by the three-month Treasury. Recall that it was not long ago (pre-November 8, to be exact) that the industry and most market prognosticators were convinced that we were firmly in a “lower for longer” interest rate environment. Talk and expectations of rate increases by the Fed seemed to pass each year with no action, as domestic short-term rates rapidly approached zero percent and the 10-year Treasury (considered the best barometer for relative mortgage rates) fell precipitously below 1.5 percent in Summer 2016. As some foreign countries began to move rates into negative territory, it was easy to understand why the Fed would be focused on such a possibility domestically, and thus clearly signaled in early 2016 that it not only wanted to see how banks might financially respond to a hypothetical negative rate environment, but possibly, as important, did they have the operational and systems capability to price and track interest rate products below zero percent. Clearly, recollections of Y2K concern over the potential for operating systems to crash as the calendar clicked forward from 1999 came to mind, although not with the same level of heightened angst as technological expertise and oversight in the banking industry has grown robust since that time.

And while CCAR scenarios in earlier years tended to foreshadow Fed concerns – negative rates and double-digit unemployment in 2016, increased inflationary pressure and possible stagflation in 2015, along with a dramatic spike in oil prices and its specific implications on portfolios at many Texas banks (okay, on the last one, the Fed was topically correct, but directionally way off as soon after the release of the Fed scenarios oil prices dramatically plummeted); in 2014, movements in macroeconomic variables that largely mirrored the environment experienced during the last financial crisis – there also developed recommendations to have banks run “idosyncratic scenarios” (focusing on stresses that may be unique to their organization, or particularly acute to their portfolio and operational mix), as well as hypothetical “break-the-bank” analytics that might help banks to isolate risks and exposures that under certain circumstances could bring an institution to its knees.

As stated earlier, I am a big believer in the intellectual discipline, analytical rigor, and resultant candor and discourse stress testing helps to generate as part of management and Board governance of their institutions. While some of the required public disclosures may have outlived their relative usefulness, let’s not be too hasty to simply kick to the curb the significant ongoing benefits of the stress testing regimen.

In closing, attached please find our monthly summary of Michigan’s financial institutions. As you and your Board take your organization forward, please do not hesitate to reach out to me and/or my colleagues at ProBank Austin if we can be of any assistance in helping you to assess the competitive landscape. Best wishes for continued success in 2017!

Michigan Banking Summary February 2017