The Supervisory Capital Assistance Program-Part X

This is the tenth in a series of articles on the SCAP.

The participating BHCs were asked to submit their projections, in regard to losses they were likely to incur on loans, securities, and trading activities, and the resources they could muster to absorb such losses.   In the last two articles we had examined the loss projections of the firm.   In this article, we shall examine the projections for loss absorptions to be made by the firms.

Loss Absorption:  With regard to the projections on the ability of the firms, to absorb the losses under the two scenarios, they had to provide suitable evidence to support their contentions.   And this included the projections on the pre-provision net revenue(PPNR).   PPNR denotes the income left with the firm after all the non-credit related expenses are accounted for, but before provisions, write-downs, or losses are accounted.

The firms were asked to submit projections for all the major components of the PPNR.   They were also expected to justify their projections with supporting details, evidence, etc, especially in respect of those that related to their growth in business or market share.   Also, where the PPNR projections exceeded the 2008 values under the more adverse scenario, the firms were asked to provide solid facts and figures, to have the projections accepted by the supervisors.

Apart from figures for the PPNR, the firms were also asked to submit their forecast for ALLL available to absorb credit losses on the loan protfolios, under both the scenarios.   The firms were also expected to retain a sufficient allowance at the end of the specified two year period.   After all the projections were made, the supervisors assessed the sufficiency of loan loss reserves, having regard to the size, composition, and risk characteristics of the loan portfoliok, at the end of the scenario period.

One of the major objectives behind the forecasting of losses, and the capacity of the firms to absorb them, is to restore public confidence in the firms, about their ability to perform their normal functions, especially lending, even under sever economic conditions.   Especially in the context of a worsening economic situation, with a string of adverse factors cropping up one after the other, it is imperative for supervisors to discipline the firms, to ensure compliance of all the norms applicable.   In spite of all the steps to calculate the optimum level of capital under the present circumstances, to meet the exigencies arising out of the economic downturn, it is still not 100% certain that the purpose of this exercise would be served.   The reason for this being the uncertainty regarding the range of potential macroeconomic outcomes to contend with, the inherent relationship of the firms with the macroeconomic scenarios, the continued relevance of the historical facts in the current scenario, and the possible changes in the consumer behavior, in the face of macroeconomic and institutional changes.

                                                                                                           To be concluded.

Acknowledgement:  Adapted from the official document of the Board of Governors of the Federal Reserve Banks.

The Supervisory Capital Assistance Program-Part IX

This is the ninth in a series of articles on the SCAP.

Loss Projections(contd):  The BHCs were required to make loan loss projections for the years 2009 and 2010, for the 12 categories of loans as discussed earlier.   In this regard, the firms were instructed to make their estimates on the basis of their defaults in payment obligations, or cash flow losses, and not on the basis of losses incurred in relation to mark to market values.  

The supervisors also provided the firms with a range of indicative 2 year cumulative loss rates for the prescribed 12 categories of loans, in both the scenarios-the baseline and the more adverse.   The firms were,  however, permitted to deviate from the laid down loan loss rate ranges, provided they could justify it with proper evidence and their own track record.   Where the estimates of the firms fell below the range minimum, the firms were obliged to back up their estimates with appropriate data.  

As far as the loan loss rate ranges are concerned, they were arrived at using a variety of statistical tools, quantitative models, and historical data from the firms in relation to individual loans as well as groups of loans to macroeconomic variables.   The importance given to the individual loans is on account of the fact, that certain categories of loans, like housing loans, had resulted in huge losses to the firms having exposure to them.

The above projections to be made by the firms were pegged to the loans and securities balances outstanding as on December 31st, 2008, and reported by the firms in their FR Y-9C reports.   Suitable adjustments were to be made for any significant mergers, acquisitions, or divestitures made by the firms.   Another item that the firms were to include in their loss projections, was against loans availed out of unused credit limits, and securitized assets that could be reverted to the Balance Sheet under adverse market conditions.

In case of securities held in the available-for-sale and held-to-maturity portfolios, the firms were asked to project possible slide in the values, relative to net unrealized losses, at end of 2008, as reported by them under the relevant filing.   That apart, the firms were obliged to consider possible losses from other potential troublesome areas.

BHCs with trading account assets in excess of USD 100.00 billion as of December 31st, 2008 were required to provide projections of trading related losses for the more adverse scenario.   This included losses from counter party credit risk exposures, and potential counter party defaults.   In addition, where the BHCs had made credit valuation adjustments against exposures to counter parties, who they considered potential candidates for default, provisions had to be made accordingly.

As a matter of fact, the 19 firms had conducted a stress test in February 2009, to project these losses and were required to submit details of the same as to the inputs that had gone into the tests.   It would appear from the above that, the supervisors were extra cautious, presumably, to ensure there were no slip ups from their side.

The Supervisory Capital Assistance Program-Part VIII

Losses and their absorption:  Under the SCAP, the nineteen BHCs were asked to submit their projections of expected losses, and the resources to absorb these losses, for the two year period of 2009 and 2010.   The BHCs were also expected to have the financial capacity to absorb the losses likely to be incurred in 2011.   The details of these projections are discussed below.

Loss Projections:  The nineteen BHCs that were required to participate in the SCAP exercise, were asked to submit estimated losses on loans, securities, and trading related exposures.   That apart, potential losses from off Balance Sheet exposures were also to be projected.   These projections pertained to the period of 2009 and 2010.  And these projections were to be submitted for the two scenarios, the baseline and the more adverse one.

The BHCs were asked to report projected losses on loans under twelve seperate categories namely Prime, Alternative A-paper, and Subprime mortgages under the First Lien Mortgages, Closed end junior liens and HELOCs or Home Equity Line of Credit under the Junior lien mortgages, Commercial and Industrial loans, Commercial Real Estate loans, Construction, Multi Family, and Non farm, non residential loans, Credit Cards, Other consumer loans, and Other loans.

The firms were also asked to submit projections for loans and securities held in the available-for-sale, and held-to-maturity portfolios, and in case of firms with trading assets exceeding USD 100.00 billion, for positions held in the trading account.

In addition, the firms were also asked to make necessary changes in their Balance Sheets for the value of the assets in conformity with a situation where their borrowers would utilize unused credit limits, and other assets/exposures being taken back on the Balance Sheet on account of stressful economic conditions, as also on account of pending accounting changes.

The above selection of the categories of loans corresponds to the regulatory requirements in regard to periodic filings to be made by the BHCs.   That is, in the normal course, the BHCs would be submitting several statements, returns, or filings under regulatory provisions.   So also, under the SCAP, the same kind of submissions were required to be filed.  

However, the difference between the regular filings and those required at this point of time is the emphasis placed on the qualiy of data and other information relating to the sub-categories of the loans.   The idea behind this is to know the exact composition of the various parts forming the bigger picture.

The supervisors wanted to be sure that there were no internal contradictions and conflicting positions within each portfolio, and that the overall picture was composed of compatible positions.   As a matter of fact, the firms were required to submit relevant data not relating to the above twelve categories also, just to make sure that no data or information of material importance was missed out.

The concern of the supervisors was to ensure that the projections made by the BHCs for losses and their capacity to absorb the losses, was based on realistic and consistent assumptions, which would enable them to come to the proper conclusions about the capital required by each of the BHCs.

                                                                                                         To be concluded. 

Acknowledgement:  Adapted from the official document of the Board of Governors of the Federal Reserve System.

The Supervisory Capital Assistance Program-Part VII

Macroeconomic scenarios for SCAP(contd):  As we have seen the supervisors in charge of implementing the SCAP, drew up two scenarios, to arrive at the required level of capital for the nineteen BHCs.   The baseline scenario represented the common view of those conncected with the exercise, about how severe the economic downturn would be, and for how long it would last.   There was a consensus on this issue.

The second scenario envisaged more severe economic conditions, with correspondingly more serious consequences, and also lasting for a much longer duration than expected.   Even though the economic recession under the second scenario was expected to be more severe and last longer, the supervisors, however, did not assume it to be the worst case scenario.   They intended the scenarios for the stress tests to be quite severe, but also realistic, and not unduly devastating.

In arriving at the above, they relied upon data from private forecasters, especially the Blue Chip forecasts over a long period of time, since the 1970s.   From these forecasts, it could be known that the possibility of average unemployment rate in 2010 being as high as in the second more adverse scenario was about 10%.   Other forecasts revealed that there was a 15% chance of real GDP growth being as low and unemployment as high as assumed in the more adverse scenario.

In the matter of the underlying assumptions in respect of house prices, under the baseline economic scenario, the supervisors relied upon the Case-Shiller 10 city composite index, and the Blue Chip survey.   In case of the more adverse scenario, house prices were projected at about 10% lower at end of 2010, compared to the baseline scenario.

The SCAP supervisors made the following projections, under the baseline and the more adverse scenarios, with regard to the important factors determining the economic situation:

1. As per the baseline scenario, the real GDP growth is expected to be -2.0 in 2009, and 2.10 in 2010;  the civilian unemployment rate is expected to be 8.4 in 2009, and 8.8 in 2010;  and the house prices at -14 for 2009, and -4.0 for 2010.
2. As per the more adverse scenario, the real GDP growth is expected to be -3.3 in 2009, and 0.5 in 2010;  the civilian unemployment rate is expected to be 8.9 in 2009, and 10.3 in 2010;  and house prices at -22.0 in 2009, and -7.0 for 2010.
3. As per the Consensus Forecasts, the real GDP growth is expected to be -2.1 in 2009, and 2.0 for 2010;  and the civilian unemployment rate is expected to be 8.4 in 2009, and 9.0 for 2010.   As per the Blue Chip Survey, the real GDP growth is expected to be -1.9 in 2009, and 2.1 for 2010;  and civilian unemployment rate at 8.3 in 2009, and 8.7 for 2010.   And as per the Survey of professional forecasters, the real GDP growth is expected to be -2.0 in 2009, and 202 for 2010;  and the civilian unemployment rate at 8.4 in 2009, and 8.8 for 2010.

From the above it is clear that, whereas the baseline scenario figures are an average of the other forecasters, the more adverse scenario figures are much hjigher on the negative side.   And even these figures are not considered to be the worst case scenario figures.

This then is the broad outline of the macroeconomic scenarios under which the SCAP exercise was undertaken.

                                                                                              To be concluded.

Acknowledgement:  Adapted from the official document of the Board of Governors of the Federal Reserve System.

The Supervisory Capital Assistance Program-Part V

This is the fifth in a series of articles on the SCAP.

Outline of the SCAP exercise(contd):  The nineteen BHCs included in the exercise were instructed to submit data related to their projected losses and the resources at their disposal to absorb such losses.

In order to analyze and assess the above data submitted , and to arrive at a fair judgement about its accuracy, relevance, and application, the SCAP set up teams of supervisors and analysts drawn from each of the agencies involved in the exercise.   These supervisors and analysts brought with them, expertise in a specific area like a particular asset class, for example,  housing loans, or revenues, reserves, capital, etc.   Some members of the team had special knowledge of the participating BHCs, presumably on account of their past dealings with such firms.

To start with, the firms’ submissions regarding particular classes of assets, revenues, reserves, etc., were thoroughly examined and evaluated, and where necessary, additional data and information was obtained.   The firms were asked to support their estimates, including the risk characteristics of their portfolios, with suitable reference material.

The supervisors also examined the methodology adopted by the firms in arriving at the estimates and assumptions.   Individual firms were subjected to tests and analyses about their risk management practices, underwriting practices, etc.

The supervisory teams, then proceeded to make a across-firm comparative analysis, to make doubly sure that the assessments, and estimates arrived at by the firms, were consistent with each other, as well as fitted in with the framework of the exercise undertaken.

The supervisors adopted a two-pronged strategy.   One, to apply independent quantitative methods using firm-specific data to estimate the losses and the resources available to abosrob such losses.   Second, to carry out a comparative analysis of all the firms’ estimates by applying consistent quantitative methods.

After carrying out the above analysis, the supervisory teams evaluated the amount of capital required by each firm at the end of 2010.   The procedure adopted for this purpose was based on a post-purchase accountig basis, and considered taxes, including deffered tax assets and dividends on preferred stock.

The supervisors then examined the need for additional infusion of capital in the BHCs, based on the above exercise, and advised them accordingly.   These firms were required to equip themselves to be in a sufficiently strong financial position to play their designated role as financial intermediaries.

As a result of the above exercise, the firms are expected to have sufficient buffer capital that can go on swallowing up the losses as they occur, and still be financially strong.   In the event the economic situation recovers faster than expected, then it is possible that these firms would be left with a higher than required or justified level of capital.   That would be a burden on the firms, and also affect their bottmline.   Hence, under such circumstances, the firms would be allowed to reduce their capital.

                                                                                                   To be concluded.

Acknowledgement: Adapted from the official document of the Board of Governors of the Federal Reserve System.

The Supervisory Capital Assistance Program-Part III

This is the third in a series of articles on the SCAP.

Scope of SCAP (contd):  The supervisory authorities in charge of the SCAP, consider the program to be visionary in scope, even though its application is limited to a time period of two years, i.e., 2009 and 2010.   The SCAP analysis aims to arive at as-accurate-as-possible figures for the loan loss reserves(amount necessary to cover estimated losses in the loan portfolio)expected to be held by the BHCs as at the end of 2010.  And whether these amounts are sufficient to digest the losses expected in the year 2011, by these firms.

If the answer to the above question is ‘yes’, then it reflects the sufficiency of capital held by the concerned firm.   And it’s ability to stand up to the challenges of the current economic downturn, as well as, a worse situation, in future.   If however, the answer is ‘no’, then the concerned firm would be expected to take suitable steps to acquire and supplement its capital, especially the common equity portion, such that it attains the capability to sop up the losses expected upto the year 2011, and come out on top of the situation.   Such capability on part of the firm, would afford the necessary protection to it’s depositors and creditors.   The SCAP exercise determines the sufficiency of the loan loss reserves expected at the end of 2010 to ingest the expected losses in 2011, by the BHCs.   

As for the time horizon chosen for the SCAP exercise, it addresses the risks that the firms are exposed to, with special reference to their loan exposures undertaken in the years 2006 and 2007, as the underwriting standards in those days were not upto the mark.   In other words, the firms might have taken loan exposures that they should not have, and therefore, there is more likelihood of these exposures converting into losses, forcing them to make provisions for the same, further affecting their profitability.  

The purpose of opting for the above time horizon is that, it offers a sort of middle ground between the baseline scenario for the macroeconomic situation, and the more adverse scenario of sustained economic downturn, followed by a upturn in the situation resulting in real growth of the GDP.   Thus the supervisors believe this time period to be apt for the SCAP exercise.

Despite the elaborate mechanism put in place by the supervisory authorities to carry out the SCAP exercise, they do acknowledge certain shortcomings in it.   For instance, it does not take into account the losses already taken by the firms on their various exposures between 2006 and 2008.   It is also admitted that the losses are not calculated on a “lifetime” basis, that is, from the origin of the loan asset, till the end of it’s life cycle.

However, care has been taken to include the major or significant portion of such losses.   These losses include charge offs(a write off that is no longer shown as a receivable in the books of accounts), and write downs(reduction in the book value of the asset to conform to its market value) on securities held in trading and investment accounts, and losses associated with the acquisition of failed financial institutions.

To sum up, the scope of the SCAP is quite comprehensive, and expected to bring forth a true picture of the capital requirements of the participating firms.

                                                                                      To be concluded.

Acknowledgement:  Adapted from the official document of the Board of Governors of the Federal Reserve System.

The Supervisory Capital Assistance Program-Part II

This is the second in a series of articles on the SCAP.

Scope of SCAP:  Under the auspices of the SCAP, American banking regulators obtained information and data from the nineteen participating BHCs (Bank Holding Companies), on the following aspects of their operations:

1. Projection of losses likely to be incurred by the BHC in relation to it’s loan exposures, investments, and trading activities.
2. The capacity of the BHC to ingest such losses.

The above information and the relative data, would enable the supervisors to determine how much capital would be required by the BHC to carry on its lending activities under a more than expected adverse macroeconomic environment.

Actually, the proposal of the supervisors in respect of the capital required by the BHCs, corresponds to the existing and normal requirements in force at present.   However, in view of the ongoing economic downturn, and the possibility of the same becoming worse in the coming days, it is felt that BHCs must attain and maintain a capital level that would take care of their regular requirements, as well as meet unexpected losses.   Here, the supervisors laid special emphasis on common equity, as distinguished from common stock.   A respectable proportion of common equity would better serve the purpose of protecting the interests of the depositors and creditors, by absorbing the unexpected losses.

It was observed in the SCAP process, that the majority of the loans in the books of the firms were held to maturity, and hence subject to the application of the accrual accounting principles.   This type of accounting takes into account, both cash, as well as, credit sales undertaken during a particular period.   The loans subject to accrual accounting are held at amortized cost(that part of the value of the asset that is written off), net of an allowance for loan losses(excluding the amount of provision made for loan losses).  

Further, in the accrual system, the loan portfolio being linked to it’s relative maturities, is valued in relation to repayments, that is , when repayment becomes doubtful, the value of the loan asset is reduced correspondingly.   And, in case there is a possibility of market fluctuations adversely affecting the price of the loan asset, it’s value is again reduced correspondingly.   Hence, the SCAP also adhered to this accounting system, in order to make this process, consistent with existing systems.

As pointed out earlier, the major portion of the BHCs’ loans were held to maturity, and not on mark to market basis.   Under the mark to market basis of valuations, the loan assets would have to be valued in relation to market prices(the value of the loan assets to reflect the current market value, and not the book value).   There is no unanimity on whether the losses suffered by the BHCs could be attributed to their adherence to this system of accounting, rather than the mark to market system.

On their part, the supervisors responsible for the SCAP, went along with the accounting system in vogue, to make the process consistent with the ground realities, and to obtain the best results possible, from this exercise.

                                                                                         To be concluded.

Acknowledgement:  Adapted from the official document of the Board of Governors of the Federal Reserve System.

The Supervisory Capital Assistance Program-Part I

This is the first in a series of articles on the SCAP.

The Supervisory Capital Assistance Program, or the SCAP, is a joint program of the Board of Governors of the Federal Reserve System, The Federal Reserve Banks, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency.

The above program was initiated in the month of February 2009 and continued through April 2009, to determine the amount of capital required by the 19 largest financial institutions, or the large Bank Holding Companies(BHCs) in the United States, that owned assets over USD 100.00 billion each.   These institutions were selected for the special program in view of their critical importance to the American financial system, as they jointly hold two thirds of the assets, and one half of the loans in the U.S. banking system.

We shall study in detail, in a series of articles, starting with this, what is the SCAP, its aims, and its methodology, and expected results from its implementation.

As pointed out earlier, the SCAP seeks to determine the capital required by the BHCs.   This level of capital is with reference to two issues:

1. the capacity of the BHC to absorb losses, suffered by it, from it’s loans and investment portfolios, and trading activities.
2. the ability of the BHC to continue lending in a worse than expected macro economic scenario, as it would in the normal course.

After absorbing these losses, the BHC must be in a position to continue lending as usual.   That would be the ideal level f capital required by large BHCs in the current scenario.

On the issue of capital, the emphasis here is on the common equity.   Common equity is part of the common stock of a company.   The extent of the common equity helps in determining the financial stability of the company.   A capital structure having a decent proportion of common equity would serve to protect the interests of the depositors and creditors of the BHC by absorbing unexpected losses.

In view of the low public confidence in the banking system, and the risk of further deterioration on account of the worsening economic situation, the supervisory authorities want the large BHCs to maintain capital at a level, that would not only meet their present requirements, but also help them tide over a longer period of economic downturn.

As discussed earlier, the common equity part of the capital would be given importance.   In fact, this is in line with the extant guidelines on regulatory capital.   The SCAP has been dovetailed with the normal supervisory processes, and procedures with particular reference to capital requirements of the BHCs.   And these capital requirements are linked to two scenarios.   One, the current scenario as it is, and second, a worse than expected future scenario that continues to persist for a longer than expected period, doing more damage than expected.  

The longer the economic situation remains unstable, the higher the probability of losses likely to be suffered by the BHCs.   The SCAP analyses the effect of such scenarios on the BHCs in order to determine the level of capital required by them, to absorb the losses arising from their lending and investment portfolios, and to continue lending as in normal times.

                                                                                       To be concluded.

Acknowledgement: Adapted from the official document of the Board of Governors of the Federal Reserve System.

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