Stress testing in the context of Bank Holding Corporations (BHC) or what is formally known as the Comprehensive Capital Analysis and Review (CCAR) is an annual exercise conducted by the Federal Reserve (or relevant Central Banks) and refers to the series of assessments and tests that examine the ability of an organization to withstand adversities such as Macroeconomic instability (e.g. Sudden surge in unemployment rates) and Market risk (e.g. Devaluation of company assets due to the Stock Market Crash) or Operational Risk (e.g. Legal Risks ).
The intuition behind this acid test being to ensure that financial institutions have sufficient funds to tide over periods of economic distress and continue smooth operations without causing global downturns as was witnessed during the financial crisis.
Presently 30 BHC controlling > 80% of assets in the financial sector are subject to stress tests. The key metrics that indicate the ’preparedness’ of the institution to deal with unforeseen circumstances are expressed as a percentage of the total Risk Weighted Assets (RWA) of the BHC.
Generally the Risk Weight assigned to an asset is increasing function of exposure and decreasing function of the liquidity of the underlying asset. For example cash or currency held by the bank as assets is completely liquid and only subject to inflation risk will be assigned a zero weight, likewise deposits insured unconditionally by FDIC or National Credit Union Administration will enjoy a zero weight. Exposures to U.S depository and credit unions are assigned a 20% weight. (For more details click here).
The key indicators are defined as follows:
1. Tier 1 Capital or Primary Capital or Core Capital: It is primarily composed of common stock and disclosed reserves/retained earnings. It is the least risky component and as the recent crisis demonstrated that retained earnings act as the most important shock absorber in the face of turmoil. Under the BASEL III guidelines common stock and retained earnings should constitute at least 85% of the total Tier 1 capital. The remaining 15% - what is designated as Additional Tier 1 - can constitute of subordinated instruments with fully discretionary dividends or coupons with neither a maturity date nor incentive to redeem.
BHCs with higher percentage of Tier 1 capitals are viewed more stable. A more detailed insight into what constitutes Tier 1 capital can be found here. As of January 2014 the Tier 1 capital requirement is 5.5% of RWA.
The following graph depicts the Tier 1 capital ratios of the major players in the US banking landscape (as of March 2014)
2. Tier 2 Capital or Supplementary Capital: While the main function of Tier 1 capital is to protect the bank from insolvency and continue operating in the face of adversity, the main purpose of Tier 2 capital is to ensure that debt obligations such as depositors and senior creditors are repaid in case the organization fails. The major components of Tier 2 capital include Undisclosed Reserves, Revaluation Reserves, Loan Loss Reserves, Hybrid Debt capital instruments and Subordinated Term debt. For more details click here. As of January 2014 Tier 1 and Tier 2 capital combined should constitute 8% of total RWA.
3. Tier 3 Capital: Assets which are unsecured, subordinated with a minimum maturity of two years and not exceeding more than 250% of Tier 1 capital are classified as Tier 3. The main function being to hedge against marker risk. Under BASEL III guidelines, this branch will be phased out.
Majority of the Central Banks follow the guidelines set by Basel Committee on Banking Supervision to define metrics defined above.
Under BASEL III, the guidelines towards risk management have become more stringent and focused towards strengthening global capital. The system proposes additional metrics – mandatory maintenance of Liquidity Coverage Ratio and the Net Stable Funding Ratio.
The revised framework thus plays the dual role of harnessing risk and acting as a buffer against excess credit growth by acting as an automatic stabilizer in an overheating economy.
In the context of company performance and valuations stress tests play an important role. Stress tests take into account future dividend payments, stock re-purchase plans or acquisition/divesting decisions of a financial institution, hence, satisfying the requirements indicates a high likelihood of its capital plan being approved by the Central Bank in place. In addition to the quantitative dimensions of maintaining the required ratios qualitative aspects such as business planning in the context of a global exposure is also taken into consideration.
An interesting example to highlight here would be the case of Citigroup during Q1 earlier this year when Citigroup although satisfied the Tier 1 capital requirement (6.5%) was not allowed by the FED to increase its dividend payments. A direct consequence was the decline in share prices as Citigroup compared to its peers continued to remain undervalued.
Good effort on this write-up, but don't confuse your definitions. Tier 1 Capital is not the same thing as Tier 1 Common Capital or Common Equity Tier 1. Tier 1 capital comprises Tier 1 Common Capital + Additional Tier 1. The first graph you show is the Tier 1 Common Ratio, not the Tier 1 Capital Ratio as you have described it (it even has the correct label on the graph).
You're hopping back and forth between Basel III (no need to capitalize all the letters, it's not an acronym) as published by the BCBS and U.S. Basel III put out by the Agencies. As any BHC in the US will tell you, they're very different, and the BCBS rules have no legal standing in the US, although they are still important for understanding this topic.
I'm not sure where you got the information that the Tier 1 Capital requirement is 5.5% - that seems very low. And the 85/15 split for Tier 1 capital is just off.
You didn't mention the capital conservation buffer in the requirements - that's a very important part of capital requirements that you're leaving out.
The CCAR is not performed by the "Federal Reserve or (relevant central banks)", it is only conducted by the Federal Reserve. CCAR is a process that only takes place in the US. Other countries and jurisdictions have, or are in the process of implementing, their own stress testing but they are not the same thing as CCAR.
Also, no love for DFAST? Hardly a cheat sheet when you leave out more than half the stress testing done by US banks. Maybe I'm being unfair and you meant this as the first part of a series, in which case, carry on!