Introduction

The Comprehensive Capital Analysis and Review (CCAR) was created in the wake of the 2008 financial crisis as a way for regulators to ensure that financial institutions are resilient enough to face future disasters. This test is administered once a year by the Federal Reserve Board and assesses the resiliency of Bank Holding Companies (BHCs) that have at least $50 billion in total consolidated assets based on their capital adequacy and capital planning.

Relevant institutions submit their CCAR reviews in order to build confidence with the general public and demonstrate that they are prepared in the event of a potential disaster. Firms are incentivized to give their CCAR assessments top priority because failure to pass the test will bar a firm from taking “capital actions,” such as distributing dividends or share buybacks, which senior management and investors would find unacceptable.

Capital

An understanding of different types of capital is essential.  CCAR’s main function is to create a clear and thorough understanding of a financial institution’s overall assets and how they will be managed in times of stress. These assets are first “weighed” by their level of riskiness to create the Risk Weighted Assets (RWA) figure, then categorized as Tier 1, Tier 2, or Tier 3 Capital.

Tier 1 Capital includes assets that are immediately available in the event of an emergency and can be efficiently utilized in a way that will keep losses minimal. An example of this is common equity because it does not have to be repaid and there are no payments/dividends owed on it. Tier 2 Capital includes assets that can help keep losses minimal under distressed bank conditions, but not as efficiently as Tier 1 assets. An example of this is long term subordinated debt because it must be repaid (even if at a later time) and payments (like interest) are owed, which devalue the asset. Tier 3 Capital typically consists of debt that must be paid back very quickly (e.g. subordinated short-term debt, senior tranche debt, etc.). Because Tier 3 Capital must be paid back on an accelerated schedule, it cannot be relied upon for the purposes of CCAR and is therefore excluded from calculations of capital adequacy.

During the stress test, the Federal Reserve Board uses a figure called the Capital Adequacy Ratio (CAR). The Fed inserts the bank’s capital types into an equation that results in a number which is either higher or lower than the CAR. This bar is set to prevent commercial banks from becoming leveraged to the point of insolvency in the event of economic or financial turbulence. The equation for the CAR is as follows:

CAR = [Tier 1 Capital + Tier 2 Capital] / [Risk Weighted Assets]

Often, a large portion of a financial institution’s assets are loans (debt), and the “weight” or level of risk is assessed by looking at the source of the loan and the underlying value of the collateral. A common example would be a loan for a commercial building. The regulators would consider whether the building is fully leased, to understand if it is generating enough interest and payments from leases to pay the loan off, while also considering the value of the building itself.

Stress Testing and Capital Governance

CCAR assesses firms on both a qualitative and quantitative basis.

Qualitatively: the Federal Reserve will examine how robust, and forward-looking an institution’s capital planning processes are. They will also evaluate a firm’s controls and accountability structures for capital management and capital credit risk management. This includes assessment of a firm’s:

  • Corporate governance structure
  • Risk management
  • Hierarchy of responsibility
  • Capital Plan

The Capital Plan is a written presentation of a company’s planning strategies and capital adequacy processes, which includes the following mandatory elements:

  • Assessment of the expected uses and sources of capital over the planning horizon (including estimates of projected revenues, losses, reserves and pro forma capital levels)
  • Description of all planned capital actions over the planning horizon
  • Discussion of business plan changes that are likely to impact capital adequacy or liquidity
  • Description of the process for assessing capital adequacy
  • Description of capital policy

Quantitatively: firms are assessed based on various “stress tests.” A stress test is an examination of what would happen to a bank under varying adverse conditions (including regional economic strain, national economic strain, global economic strain). These conditions are simulated with the use of financial models, some of which are mandated under the Dodd Frank Act Stress Test (DFAST) (a related capital review which is purely quantitative), and others which are designed by the firm itself. In addition, the largest and most critical firms in the world are tested for how they would respond to Global Market Shock (GMS). GMS effectively simulates aspects of the 2008 financial crisis to evaluate how SIFIs would respond in a similar scenario today.

Consequences

Financial institutions that pass CCAR review are permitted to raise and pay out their dividends and repurchase shares.

Financial institutions that fail CCAR testing may fix discrepancies in their capital planning and internal control policies and resubmit their capital plans to the Fed for approval. Until a firm passes CCAR or creates changes that receive the Fed’s approval, it is barred from taking capital actions. Additionally, the results of CCAR are made public, and failing hurts the reputation of the institution often resulting lack of confidence from the general pubic.