RegCap vs. E-Cap: Getting It right
Stress testing gives regulators a view into capital planning
Risk Research and Quantitative Solutions
In one of our previous articles for Risk Insights (see Risk Capital and lessons from the Titanic), we explain economic (or risk) capital compared to regulatory capital (RegCap) and available capital, or capital on hand. In this article, we plan to take a deeper dive into the relationship between stress testing, RegCap and E-Cap.
Economic capital (E-Cap), an internal measure derived from the firm’s risk appetite, is the amount of additional equity capital required to limit the probability of financial distress to a level considered acceptable by senior management. It differs from regulatory capital in that RegCap is an external measure required by statute and has nothing to do with senior managers’ opinion of the amount of capital required by the firm’s risk appetite.
Despite appropriate levels of E-Cap (which were, at a minimum, equal to levels of RegCap), there were still colossal failures in the financial services industry during the 2007-2009 financial crisis. E-Cap or, more specifically, management’s opinion of soundness under a hypothetical event like an unlikely large economic downturn, did not sufficiently predict the level of capital needed to cover severe losses experienced during the crisis. As we now know, many banks experienced losses greater than what they hypothesized.
Regulators still require the maintenance of E-Cap levels. As pointed out in the “Titanic” article, despite its limitations, E-Cap still gives us the best and broadest view of risk. It’s just the lack of transparency in the E-Cap determination process that gives regulators heartburn.
Now, in addition to management’s viewpoint, regulators want banks to determine capital levels under three hypothetical events or scenarios:
Baseline - average projections from surveys of economic forecasters.
Adverse - moderate US recession defined as a 1% decline in the US’s real GDP and an unemployment rate of 9.25 percent.
Severely Adverse - severe US recession with unemployment peaking at 11.25 percent.
Enter stress testing and stress scenario capital calculations
Two stress testing regimes exist today: the Dodd-Frank Act Stress Tests (DFAST) and the Comprehensive Capital Analysis and Review (CCAR).
- DFAST applies to banks that have greater than $10 billion in assets and contains a standardized set of capital action assumptions. Under DFAST, the Federal Reserve projects each bank’s balance sheet, net income, and resulting post-stress capital levels, regulatory capital ratios, and a Tier 1 Common risk-based capital ratio under the three scenarios described above.
- CCAR applies to 31 banks—those with assets of more than $50 billion (exceptions are GE Capital, TD Bank US Holdings, Charles Schwab, and BancWest Corp.)—and uses each bank management’s planned capital actions. Here, the Federal Reserve qualitatively and quantitatively evaluates each bank’s plans to make capital distributions for dividends and stock repurchases, for example.
Stress tests don’t produce a fourth type of capital (in addition to E-Cap, RegCap and operating equity capital). Rather, the capital calculated through the new stress testing regimes is regulatory capital. Now, the regulators have a view into capital planning where they had none before.
Stress testing is here to stay; it’s the new normal. But you aren’t alone – all banks are in the same boat.