In this issue of The Institutional Risk Analyst, IRA CEO Dennis Santiago discusses observations of the latest round of Notices of Proposed Rule Making (NPRM) from bank regulators for bank stress testing.

Managing systemic risk -- the kind that gives rise to "Black Swans" -- is what the Dodd-Frank Act was meant to do. U.S. regulators are methodically -- albeit slowly -- marching in that direction, but the jury is still out on whether systemic risk will actually be reduced as a result of these efforts.

Part of the lack of speed comes from the fact that multiple regulatory agencies have to coordinate with each other. The other part is that theory about how to actually go about doing meaningful and comparable stress testing has been somewhat of a challenge to bank regulators.

The initial request for comment by regulators on the stress testing back in the summer of 2011 was a hopeless guidance statement that was little more than "everyone try to do your best" that would have resulted in excessive implementation costs and -- more important -- an inability to meaningfully compare the analysis of one bank to another. IRA was one of the few respondents to that request for comment where we advocated that regulators consider using standardized stress tests based on stressing banks with a broad battery of significant systemic shock scenarios and requiring reporting on specific measures of merit as well as explanations – including methods and assumptions -- of the risk mitigation strategies contemplated by bank management. Click Here to see our comments.

To prove that it could be done we built a prototype Stress Test Edition of the IRA Bank Monitor that enabled subjecting every bank to identical stress testing. We believed – and continue to believe -- very strongly that creating a stress testing regime that mandates apples-to-apples comparability is what is needed for the United States economy to "manage" and not just endure systemic threats. Without such an implementation approach to Dodd-Frank, our banks, regulators, policy makers, markets and the general public would still be flying blind.

FIL-7-2012
Click here to read the it.

On February 3, 2012 the FDIC released FIL-7-2012 adding another turn in the implementation plan for the Dodd-Frank Wall Street Reform and Consumer Protection Act. This particular NPRM notifies FDIC-insured state nonmember banks and FDIC-insured state-chartered savings associations with total consolidated assets of more than $10 billion that they -- like the bank holding companies and member banks -- are also required by Dodd-Frank to conduct annual stress tests. FIL-7-2012 contains provisions that do indeed move towards standard and comparable operational stress testing. Naturally we like the direction the testing regime design is going because it conforms to the census based approach we use in the IRA Bank Monitor that bankers, bank vendors, corporate treaurers and individual depositors buy and use every day from us on the internet.

Among other things, FIL-7-2012 calls for assessing the potential impact of economic and financial stresses on the earnings, losses, and capital of a covered bank over a nine quarter planning horizon, taking into account the current condition of the bank and its risks, exposures, strategies, and activities. The proposed rule affects both FDIC member banks and covered state nonmember banks although nonmember banks will only be required to perform a capital adequacy stress test once a year. It asserts that the FDIC will develop three standardized stress scenarios each year that will change in accordance with prevailing economic conditions.

The proposed rule also states that the results of the stress tests will be "public" and that the public summary is to include projections of losses, pre-provision net revenue, loss reserves, net income, and pro forma capital levels and ratios over the planning horizon under each FDIC test scenario, and that the public disclosure shall include a general description of the risks covered and stress testing methodologies used.

Making Differential Shock-Response Patterns More Transparent

We particularly like the public disclosure part of FIL-7-2012 a lot. As we used to say about the dubious "pillars" of the Basel process, there is no market discipline without public disclosure. The list of items to be reported says the bank regulators are focused on two things, loan losses and capital adequacy. We think the regulators should also consider enumerating a list of other operational risks that must be considered by the banks.

In our discussions with bankers as we have been working on the Stress Test Edition of the IRA Bank Monitor, we have run into instances of ostrich behavior, that is, reluctance by some bankers to consider certain types of business risk. We believe they are not likely to apply rigor to their more dire – and uncomfortable – areas of risk analysis unless told to do so. We suggest regulators explore the areas of policy risk, market risk and competitive risk at the systemic shift level, not just to help management but also to support good corporate governance at the board level.

Policy risks would include changes in capital ratio testing criteria and minima such as adoption of Basel III Accord standards that would add Tier1 + Tier 2 to RWA Ratio and Tangible Common Equity Ratio minimum criteria to the process. T1+T2/RWA ratios tend to affects smaller banks more abruptly and we have found that Basel III’s 4.5% TCE minima does impact some larger banks. In other words, we’ve already found that policy risk affects the various strata of the banking industry differentially. The IRA Bank Monitor was reprogrammed to begin tracking all of these capital test points in 2011 including the Basel III test points and now provides tracking reports on these figures of merit.

Other policy risks include the net effect of non-performing mortgage resolution, an area where the U.S. economy continues to play the "kick the can down the road" game. We see a broad variety of coping strategies in play as banks deal with their inventories of troubled assets and winnow down their overhangs of delinquencies, non-accruals and REO’s to document their accounting rationale to release balance sheet loss reserves back to their income statements to make investor relations expectation numbers. And then there’s mother of all policy risks, ZIRP or Zero Interest Rate Policy, that sucking sound in the room draining blood from Main Street; more on this below.

Market risks such as customers changing deposit and borrowing habits are very real and even tiny shifts in movement like consumers doing "Move Your Money" in the direction of community banks and credit unions can give rise to things like the doubling of uncertainty margins in core deposit volatilities, the kind of stuff that keeps chief risk officers up at night.

Other market risks include strategic walk away risks on commercial lending giving rise to exposure at default and the lack of lending demand of the type that meets credit quality minima of the current risk adverse landscape. This is the kind of stuff that creates pent up supply and demand that is the mother of invention for non-bank business alternatives that may or may not, in turn, create new systemic risks to worry about.

Competitive risk is something we at IRA see every day as we observe each and every active bank in the United States. One of the biggest risks banks face is the fact that market share – particularly among the bigger players – is very much a zero sum game. Strategies can and do run into problems. Take this tale from the Western provinces for instance.

When Independent National Mortgage Corporation better known as Indy Mac failed, a group of financial wizards with Goldman Sachs pedigrees picked it up from the FDIC and set about building One West Federal Savings Bank. They grew the institution via additional acquisitions of weaker California banks eventually picking up First Federal of California and La Jolla, FSB amassing a goodly treasure chest of FDIC loss share agreements.

One West then set about a plan to turn this strategic advantage into a major California retail bank out to take share from small, midsize and large institutions. Television ads hit the airwaves and I remember thinking at the time that most classic of Midtown Manhattan utterances, "Hmm, well that’s a gutsy move."

What One West failed to note was that there was another banker who had also bought big in California. Jamie Dimon had picked up Washington Mutual and all of that bank’s branches and he was setting about – you got it – building a retail banks out to take share from small, midsize and large institutions. And Mr. Dimon was out to take chunks of zero sum game from powerhouses like Bank of America and Well Fargo. Television advertising hit the airwaves also initially emphasizing the mighty reputation of J.P. Morgan coming to subdue the Wild West.

Of course that was about the time Arianna Huffington kicked off "Move Your Money" creating reputational risk for anything attempting to migrate beyond the thirteen Burroughs. The marketing campaign was rebranded to emphasize the less obtrusive Chase -- sans the Manhattan -- label. But in hard ball zero sum competition, Bank of America – which IRA’s analysis shows remains the most efficient retail bank on the planet able to hold twice the deposits per county with half the number of branches versus any peer – and Wells Fargo – a bank that sometimes claims to be the biggest community bank on the brick and mortar scene with a vast number of physical locations – simply were not about to let new entrants take customer base away from them. They set about revamping their own business practices to thwart the carpet baggers from the East. The saga continues.

This story is repeated in differing scales in pretty much any other geographic region or asset group strata one cares to look at. In a ZIRP capped economy, it’s a dog eat dog business environment with banks trying to take share of other banks. Plans have a way of not working out quite as planned. We have yet to see this type of beggar they neighbor competition treated as a measured risk parameter in bank regulation analysis.

We believe that it is in the interest of systemic risk management to be asking banks to consider these explicit sources of risk when reporting on their operations. Painful as it is to some, transparency that reveals they have their heads in the sand will actually help them and the economy in the long run. In the military, they call that "training up".

Observing Some Numbers

We asked the IRA Bank Monitor to pull up which FDIC certificate holders will be affected by FIL-7-2012, when approved and it gave us back a list of one hundred and nine (109) institutions based on our September 2011. Of these banks, nineteen (19) are super large over $100B asset institutions.

The other ninety (90) had reported assets between $10B and $100B as of September 30, 2011. We also asked the IRA Bank Monitor to summarize information on institutions in the $1B to $10B range and those under $1B assets for comparison purposes just because our machinery can test these institutions just as easily, something that we thing the community banks with assets below $10B would be wise to do.

How Many Institutions Are Affected by the Current Dodd-Frank Act Rule Making?

Notice that regulators are focusing their efforts on just a few institutions representing the greatest asset and deposit mass – but not necessarily the greatest presence on Main Street -- in the overall population of U.S. banks. The vast majority of the bank industry participants are below the radar. That deposits number includes about a $2 trillion accumulation of deposits at the over $100B’s since the beginning of the financial crisis as corporation’s lost faith in the U.S. economic engine and parked their money. The money went to these banks because private deposit insurance typically requires the bank have a safety rating. At the time the only ratings available were from the NRSRO’s. This is no longer the case due to the emergence of safety and soundness ratings by firms like IRA and others that have broader coverage than the NRSRO’s.

We regularly hear from community banks that they think ratings like ours are far more appropriate for monitoring deposit insurance as well as letters of credit because the safety and soundness analytics approach is closer how regulators examine them. As insurance company actuaries begin to learn to use these benchmarks – they do back test very nicely --, the smaller banks may be poised to argue for a far more substantial corporate version of the 2010 consumer "Move Your Money" migration phenomenon at some point. It’s a defensive business challenge that the Large Complex Institutions (LCI’s) will have to face at some point. We think this is good for a better and more vibrant economy in the long turn and we have confidence that all of these savvy and competitive businesses are up to the challenge. The reason for this will boil down to the market pressure of corporate self-interest and the need to get Main Street moving again. Take a look at the asset allocations by asset strata,

Asset Allocation Breakdown as of 3Q2011

First notice the biggest banks lend less as a percentage of their asset allocation than smaller institutions. Also notice that the really big banks are running trading desks significantly larger than their smaller counterparts who only allocate a minor portion of their assets to this aspect of financing. Most important, look at Other Assets, these include the back and forth financing money that goes between banks and the government. Try thinking of it as a related party transaction driven by zero interest rates – ZIRP again -- that funds the government instead of the Main Street economy.

At about a trillion dollars, the money seeking safety via government exposures on the books of the banks is not an insignificant amount. It does directly offset what’s available to the U.S. loan base. One astute commenter to IRA recently observed that we’ve turned the banking system in to a government hedge fund by around that amount. Ultimately, it’s probably a neither here nor there thing for the banks. They’ll allocate assets to wherever conditions present opportunity. What it really says is that the U.S. Treasury and the U.S. government have a "firm specific risk" to contend with when the day comes this systemic hedge fund is closed.

What are we doing?

IRA is committed to continuing to improve the Stress Test Edition of the IRA Bank Monitor so that systemic maneuvering capability is available not just to the over $10B banks but to the far larger number of smaller institutions. Just the $1B to $10B population outnumbers the big houses 5-to-1 and we hear from this group all the time as they ask themselves questions about doing M&A to get bigger.

And when one goes small, you start to deal with stress testing not just the smallest banks but the credit unions as well. For first pass assessment and monitoring, the computers don’t really care how big or small you are as long as you file a complete Call Report, Y9C, or Form 5300. For privileged testing on proprietary data to set up sensitivity and uncertainty measures, it actually works better for all these smaller ones to use standardized methods to cut down on the cost and risk of using theorists at each firm. It’s actually duck soup data analysis compared to analyzing and cleaning up over 10 million records of internet search engine traffic records.

The bottom line is that the cat’s already out of the bag on all of this and the tidal forces are already in motion. The real question is whether regulators and industry will be smart enough to get ahead of the curve this time. The last time I made such a bold statement about systemic threats and opportunities was in 2007 when IRA’s analytics were clearly pointing at an impending debacle in the financial soundness of the banking system.

I’d show the data to CRO’s and they’d have nervous breakdowns right there in front of me in the meeting rooms. I was told "If your numbers are right it means these banks are insolvent and we’d have to bail them out to keep them alive. But it has not happened yet. So will you change your numbers?’ I said "No. I think these numbers are right."

And that was the end of that conversation until eventually nature took its’ course. I believe these harbinger indicators hiding in the margins are right again. There’s a tremendous opportunity for the United States if we take advantage of it that could turn the remainder of the decade from one of painfully coping to one of pioneering anew.

These are the 109 FDIC certificate holders will be affected by the Over $10B Asset regulations of the Dodd-Frank Act. Multiple affected unit operating entities of larger bank holding companies may appear in this detailed level list.

CERT NAME
628 JPMORGAN CHASE BANK NA
3510 BANK OF AMERICA NA
7213 CITIBANK NATIONAL ASSN
3511 WELLS FARGO BANK NA
6548 U S BANK NATIONAL ASSN
6384 PNC BANK NATIONAL ASSN
639 BANK OF NEW YORK MELLON
57890 HSBC BANK USA NATIONAL ASSN
14 STATE STREET BANK&TRUST CO
18409 TD BANK NATIONAL ASSN
33318 FIA CARD SERVICES NA
867 SUNTRUST BANK
9846 BRANCH BANKING&TRUST CO
4297 CAPITAL ONE NATIONAL ASSN
12368 REGIONS BANK
23702 CHASE BANK USA NATIONAL ASSN
6672 FIFTH THIRD BANK
57957 RBS CITIZENS NATIONAL ASSN
33124 GOLDMAN SACHS BANK USA
16571 BMO HARRIS BANK NA
35489 ING BANK FSB
17534 KEYBANK NATIONAL ASSN
22826 UNION BANK NATIONAL ASSN
913 NORTHERN TRUST CO
57803 ALLY BANK
588 MANUFACTURERS&TRADERS TR CO
29950 SOVEREIGN BANK
33954 CAPITAL ONE BANK USA NA
32992 MORGAN STANLEY BANK NA
5649 DISCOVER BANK
19048 COMPASS BANK
3514 BANK OF THE WEST
983 COMERICA BANK
57450 CHARLES SCHWAB BANK
6560 HUNTINGTON NATIONAL BANK
13074 HUDSON CITY SAVINGS BANK
32188 USAA FEDERAL SAVINGS BANK
623 DEUTSCHE BANK TR CO AMERICAS
30746 E*TRADE BANK
35328 AMERICAN EXPRESS BANK FSB
16022 NEW YORK COMMUNITY BANK
33692 STANDARD CHARTERED BANK PLC
57565 UBS BANK USA
57282 CITIZENS BANK OF PA
16004 FIRST NIAGARA BANK NA
27471 AMERICAN EXPRESS CENTURION B
5146 WELLS FARGO BANK S CNTL NA
34968 BANCO POPULAR DE PUERTO RICO
873 SYNOVUS BANK
33184 RBC BANK USA
58978 ONEWEST BANK FSB
27334 PEOPLES UNITED BANK
59017 FIRST REPUBLIC BANK
4977 FIRST TENNESSEE BANK NA
4214 BOKF NATIONAL ASSN
58729 JPMORGAN B&T CO NA
27314 GE MONEY BANK
17281 CITY NATIONAL BANK
31628 EAST WEST BANK
5296 ASSOCIATED BANK NA
11063 FIRST-CITIZENS BANK&TRUST CO
24998 COMMERCE BANK
5510 FROST NATIONAL BANK
28330 TCF NATIONAL BANK
13718 WELLS FARGO BANK NW NA
18221 WEBSTER BANK NATIONAL ASSN
58032 BANK OF AMERICA RI NA
24735 SILICON VALLEY BANK
35055 METLIFE BANK NATIONAL ASSN
29805 ASTORIA FS&LA
2270 ZIONS FIRST NATIONAL BANK
24185 NORTHERN TRUST NATIONAL ASSN
32961 BLACKROCK INSTL TR CO NA
17985 FIRST HAWAIIAN BANK
25178 BANK OF AMERICA CA NA
34617 STATE FARM BANK FSB
13675 FIRSTMERIT BANK NA
34351 USAA SAVINGS BANK
57203 BARCLAYS BANK DELAWARE
7946 BNY MELLON NATIONAL ASSN
33029 WHITNEY BANK
7579 SUSQUEHANNA BANK
9396 VALLEY NATIONAL BANK
57053 SIGNATURE BANK
32541 FLAGSTAR BANK FSB
33653 BANK OF CHINA
30387 FIRSTBANK OF PUERTO RICO
28088 WASHINGTON FEDERAL
33947 TD BANK USA NATIONAL ASSN
18053 BANK OF HAWAII
58656 SCOTTRADE BANK
11813 BANCORPSOUTH BANK
5452 FIRST NATIONAL BANK OF OMAHA
34221 MORGAN STANLEY PRIVATE BK NA
34775 EVERBANK
8728 ARVEST BANK
33306 PRIVATEBANK&TRUST CO
17266 UMPQUA BANK
18708 CITICORP TRUST BANK FSB
23364 RABOBANK NATIONAL ASSN
28100 IBERIABANK
24107 AMEGY BANK NATIONAL ASSN
18714 FIRSTBANK
20852 CALIFORNIA BANK&TRUST
58979 BANKUNITED
30012 THIRD FS&LA OF CLEVELAND
33778 GE CAPITAL FINANCIAL INC
28892 INVESTORS BANK
18503 CATHAY BANK

About IRA Products and Services

IRA for Banking and Finance Professionals - We offer enterprise grade analytics and privileged process support for risk surveillance, compliance testing and investment research via subscription products such as the Professional IRA Bank Monitor. IRA also offers custom analytics services, hosted component tools, and bulk data feeds to clients for use in their internal systems. For more details, please call our Torrance, California office at (310)676-3300.

IRA for Business - Corporate risk management is an ever vigilant concern as the economy continues to evolve. We offer corporate CFO's and Treasurers online tools to monitor the health of their banking relationships whether they be credit facility providers, depository relationship banks, or investment counterparties. It doesn't whether you deal with only with TBTF's or local community banks, we cover them. Contact Diana Waters at our Torrance, California office for more details and to arrange a demo for your team.

IRA for Consumers - IRA believes that "ordinary people" matter. We provide consumers the same analysis horsepower to render banks transparent via an easy to buy online reports website at IRABankRatings.com system.