Financial Resilience: New Regulations and Stress Testing in Banks

After a string of bank failures jostled the market earlier this year, regulators were swift to issue a new capital requirement proposal to not only curb risks and capital shortfalls but also soothe investor, client, and depositor unease. The FDIC’s proposed regulations would require banks to reinforce their capital reserves with additional funds and would create more uniformity in banking risk assessments.

John Stephens, Workiva Banking and Financial Services Industry Principal, discusses how the new amendments and using stress testing in banks can strengthen risk management to help avert another banking tumult. Here are the key takeaways with details below:

• Mid-tier banks are sufficiently capitalized for the current proposal but those with riskier lending operations may face stiffer requirements
• Financial institutions need to further embed banking stress tests into their strategic planning, compliance, and investment operations to bolster financial resilience
• With additional regulatory proposals, more diversified deposit bases, and improved analytics, banks can better temper liquidity risks
• Enhanced risk modeling and risk appetite statements can help banks refine their interest rate and credit risk management
• Lenders sometimes underutilize technology to assess risks

Q: How prepared are mid-tier banks for the capital requirement proposal?

After the collapse of Silicon Valley Bank (SVB), First Republic Bank, and Signature Bank, many banks have posted positive results based on their quarterly earnings. They’ve also improved their Common Equity Tier 1 (CET1) ratios, a financial metric used to measure equity capital levels, so I think most are prepared for the new mandate. But if banking stress tests indicate capital shortages, some banks may be required to hold additional funds beyond minimum levels. Regulators have provided them with enough runway to increase capital buffers if they’re likely to have insufficiencies. Since most banks have previously undergone Dodd-Frank Act stress testing, they have practices and frameworks in place to support additional liquidity stress testing and balance sheet forecasting requirements.

Some analysts believe that if the current proposal transpires, it could stifle lending activities because banks may have to shore up their cushions with riskier loans that require additional capital to cover potential losses. Banks could shy away from higher-risk customers and businesses. However, the capital requirement proposal is supposed to function according to a bank’s individual risk profile. Banks that have riskier business models would be required to have deeper capital reservoirs than those with more conservative lending operations. To comply with new capital requirements, most banks may take up to four years to set aside profits.

Q: How can banks better integrate stress testing in their risk management operations?

Ideally, banks should integrate stress testing into their strategic planning, regulatory compliance, and investment decisions rather than conducting it as a check-the-box exercise just to allay regulators and investors. Authorities now expect stress testing to be embedded within business planning processes and risk management practices and to orient their risk appetite and capital pools. Leading institutions incorporate financial stress testing into their quarterly business planning and even their weekly or day-to-day strategy sessions to inform their capital adequacy levels.

Q: Why should banks look at new technology to help manage data and assess risks?

With risk modeling development, having the appropriate technology is essential to ensure that data is accurate, coherent, consistent, unique, and timely. Without the right tools—such as machine learning, artificial intelligence, and a robust regulatory reporting platform—to aggregate and harness this data, banks can inadvertently overlook real-time insights despite having a robust technology infrastructure.

However, employing new technology can lead to pushback if it would require considerable effort to alter or replace legacy systems. Banks also run into resistance when evaluating ways to connect multiple data sources to these new technologies. How can they demonstrate it would actually improve data usage? Beyond implementation concerns, there may be budgeting pushback from leadership without proven ROI benefits of a fully digitized risk and/or finance function.

Fortunately, many modern cloud platforms integrate well with existing banking systems and data sources, unlocking the potential to use more types of data in their risk assessments—with the security levels that financial institutions require.

Q: What challenges and considerations arise with evolving liquidity risks?

A major problem banks encounter is the lack of a comprehensive enterprise risk management (ERM) process to identify certain threats, including deposit risks. Compared to earlier disruptions, the 2023 banking crisis was an outlier because it was caused by a few banks' highly concentrated business models that introduced increased interest rate risks and by their reliance on uninsured deposits. Some banks may have uninsured and insured deposit bases that might not be well-diversified, as was the case with SVB because the bank catered to venture capitalists. Certain deposits may also correlate negatively because withdrawals with one category of depositor could trigger another run with a similar class.

Liquidity requirements and bank models should better incorporate risks from uninsured deposits and those from held-to-maturity securities, based on its internal liquidity stress tests. If they reveal that a significant amount of capital would be sapped from certain deposit withdrawals or from devalued held-to-maturity securities, then the bank should have contingency plans to raise more funds.

The FDIC’s long-term-debt requirement is another effort to help absorb losses from deposit flights before the agency’s insurance coverage would take effect. However, banks would be under additional strain to raise long-term debt while still showing lenders that they’re credit-worthy and resilient. This pressure has been heightened by Moody’s downgrade of 10 regional banks due to their devalued bonds from rising interest rates and liquidity risks associated with their loan activity.

Regulators have introduced other measures as well. The FDIC and FRB recently proposed new rules for large regional banks to further develop their “living wills,” or bankruptcy resolution and recovery plans (RRPs), during times of economic instability. The agency would have more options when overseeing a failed bank’s receivables or an insolvent bank that could be dismantled or sold separately.

Reducing liquidity risks is also challenged by balance sheet mismanagement. Assets and liabilities are overseen in silos, making it difficult to measure the impact of illiquid assets geographically across business lines and asset classes.

When assessing these risks, banks sometimes operate with limited analytics. Projecting cash flows, net interests, and margin or net interest income is more challenging due to a lack of granular data—especially for banks managing millions of transactions. Regulation aims to ensure that mid-tier and regional banks conduct thorough stress testing with detailed analytics and effective models to gain a comprehensive understanding of their risk exposures.

Q: How should non-G-SIB banks manage the complicated interplay of credit and interest rate risks?

Swings in interest rates significantly threaten a bank’s profitability. To limit interest rate risk, banks need to establish clear risk appetite statements and implement policy limits and targets to ensure that their exposure to interest rate risk aligns with their risk appetite.

With stress testing, especially with liquidity stress tests, models should include in their scenarios the factor combinations that drive credit portfolio performance. Banks would benefit from tools that enable them, in real time, to simulate the impact of interest rates and other macroeconomic factors.

Over time, poor interest rate risk management in banking erodes a bank’s capital. To effectively manage this credit risk, banks should have a firm capital adequacy, liquidity adequacy, and loss-absorbing capacity, or Total Loss Absorbing Capacity (TLAC), which demonstrates that it has sufficient cushioning in the event of a bank run or financial contagion.

Q: What instances of operational risk in banking cause the most vulnerabilities?

Operational risk in banking is financial attrition resulting from people, processes, systems, and external events. Within this space, banks are prone to inadequate internal processes that threaten timely reporting. This can happen when larger banks acquire smaller institutions that have legacy systems that aren’t compatible with one another, leading to poor data integrity.

Regarding external threats, regulators are placing additional requirements on banks that receive fees from wealth-management partnerships because fee structures aren’t transparent. Together, these risks expose banks to regulatory fines, additional scrutiny, and potential for further losses.

Q: Are the proposed banking regulations misplaced or too lax?

Regulations generally receive extensive feedback and comments from stakeholders before they’re put into effect. Authorities evaluate all commentary and the downstream impact of new amendments. Regulations have mostly been very intentional but also well-tailored to ensure that they don’t become overbearing and defeat the purpose of their creation: to protect banks while making sure that they’re fortified to withstand adverse economic events. So far, they’ve been effective.

Particularly, Comprehensive Capital Analysis and Review (CCAR)—a Federal Reserve regulatory assessment that evaluates banks’ capital adequacy levels and financial health—and other liquidity risk tests have played a vital role in preventing widespread financial contagions.

During the banking crisis, larger institutions bailed out faltering lenders. When in the past, collapsed banks had to rely on wider-scale government bailouts. Although the disruption was acute and revealed further cracks in the system, banks are largely more robust, adequately capitalized, and well-resourced to better manage economic turbulence than they were before.