DFAST applies to a broad range of banking  institutions and consists of supervisory- and company-run stress tests to  generate forward-looking information about institutions’ capital adequacy  for the firms’ internal use and for public disclosure. The Federal Reserve also conducts a  supervisory stress test for bank holding companies with total consolidated  assets of $50 billion or more. The Dodd-Frank Act also requires  the Federal Reserve to disclose a summary of its supervisory stress test  results. For example, the Federal Reserve’s internal  guidance instructs examiners to consider the tests as one of many tools  available to assist in the assessment of a company’s capital position and  planning process and not to rely primarily upon a firm’s internal stress test  results in assessing overall capital adequacy or risk management. The Federal Reserve’s goals  for CCAR are to ensure that large bank holding companies have sufficient  capital to withstand severely adverse economic and financial conditions  and continue operations, and have strong processes for assessing their  capital needs and managing their capital resources. According to these staff, standardized capital assumptions are used to project capital ratios in DFAST because the  purpose of the supervisory stress test under DFAST is to estimate and  disclose comparable capital adequacy information, while proposed  actions are used for CCAR, which also evaluates companies’ planning  processes. The Federal Reserve uses the results of company-run tests in  performing its CCAR quantitative assessments and has stated that a  company will not receive an objection to its capital plan based on the  assessment if it can meet minimum regulatory capital requirements under  the company-run stress tests as well as the supervisory tests. The  Federal Reserve uses the CCAR quantitative and qualitative  assessments to determine whether to object or not object to an  institution’s capital plan (including proposed capital actions such as  dividend payments and share repurchases that affect the firm’s capital  levels). In addition to the Federal Reserve, the Dodd-Frank  Act called for certain financial regulatory agencies, including OCC and  FDIC, to issue rules requiring the financial companies they supervise with  more than $10 billion in total consolidated assets to conduct stress  tests. In the CCAR  quantitative assessment, the Federal Reserve can object to a company’s  capital distribution plan if stress test results show the company’s post- stress capital ratios falling below required minimum levels. The assessment framework includes  processes to help ensure consistency across evaluations. The Federal  Reserve has provided companies with information on supervisory  expectations and peer practices related to the qualitative assessment, but  the infrequent timing of these communications and evolving peer  practices can pose challenges to companies that must meet the  expectations annually. Limited Disclosures of Information about Methodology and Objections

While the Federal Reserve has communicated some CCAR-related  information to the public and directly to CCAR companies, it has not  provided the level of information necessary for a clear understanding of  its qualitative assessment methodology, including its framework for  evaluating the extent to which companies have met supervisory  expectations and determinations, and for a clear understanding of the  reasons for objection determinations. Federal internal control standards state the importance of relevant,  reliable, and timely communications including with external  stakeholders. Federal Reserve Has Not Assessed Certain Trade-offs Associated with Scenario Severity

According to Federal Reserve staff and our review of internal documents,  the Federal Reserve has not explicitly analyzed how to balance the  choice of the severity of the severely adverse scenario—and its influence  on the resiliency of the banking system—with any impact on the cost and  availability of credit. For example, many different types of  financial crises are possible, and the single selected scenario does not  reflect a fuller range of possible outcomes. Yet, without assessing the sufficiency of a single severe scenario  in the context of DFAST and CCAR—such as performing sensitivity  analysis involving multiple scenarios—the Federal Reserve is making  CCAR decisions that may not reflect the range of potential crises against  which the banking system would be resilient and the magnitude of the  range of outcomes that might result from different scenarios. As a result, Federal Reserve  stress tests could exacerbate future financial stress by increasing  requirements on stress test participants while economic conditions are  deteriorating. Federal Reserve Management of Model Risk Has Not Focused on the System of Models

The Federal Reserve’s modeling process for the stress tests includes an  oversight structure and internal reviews, but it has not focused its model  risk management on the system of models that produce stress test  results. To estimate the effect of stress test scenarios on companies’  ability to maintain capital, the Federal Reserve has developed individual  component models that predict companies’ financial performance in the  scenarios. The results of these component models are combined with  assumed or planned capital actions of companies and form the system of  models used by the Federal Reserve. The Federal Reserve has issued  model risk-management guidance that defines model risk as the potential  for adverse consequences from decisions based on incorrect or misused  model outputs and states that it increases with factors such as greater  model complexity and larger potential impact. Federal Reserve Does Not Address Cumulative Risk and Uncertainty from the System of Models That Produce Stress Test Results

The Federal Reserve has not focused its risk-management efforts  (including those relating to model development guidance, documentation,  sensitivity and uncertainty analyses, and risk tolerances) on the system of  models that produce the stress test results—the post-stress capital ratios. This type of assessment is known as uncertainty analysis. Without systematically identifying and communicating acceptable levels of  risk in its supervisory stress test models, the Federal Reserve may be  limited in its ability to effectively evaluate and manage its model risk. Qualitative assessment disclosure and communication. Transparency is a key feature of accountability and this limited  disclosure may hinder understanding of the CCAR program and limit  public and market confidence in the program and the extent to which  the Federal Reserve can be held accountable for its decisions. The  Federal Reserve also has not regularly updated guidance to firms  about supervisory expectations and peer practices related to the  qualitative assessment. Scenario design. The Federal Reserve has conducted limited  analysis of some decisions that are important to designing stress test  scenarios. Finally, to improve the Federal Reserve’s ability to manage model risk  and ensure that decisions based on supervisory stress test results are  informed by an understanding of model risk, the Federal Reserve should  take the following five actions:
Apply its model development principles to the combined system of  models used in the supervisory stress tests. Appendix I: Objectives, Scope, and Methodology

The Board of Governors of the Federal Reserve System (Federal  Reserve) conducts two stress test exercises: the Dodd-Frank Stress  Tests (DFAST) and the Comprehensive Capital Analysis and Review  (CCAR). This report (1) compares the DFAST and CCAR exercises and  discusses company and Federal Reserve views about the exercises’  costs and benefits; (2) examines the CCAR qualitative assessment,  including the extent of communication and disclosure; (3) examines how  the Federal Reserve designs the supervisory scenarios for the stress  tests; and (4) examines the Federal Reserve’s modeling process for the  stress tests. To compare DFAST and CCAR, we reviewed Section 165(i) of the Dodd- Frank Act, the Federal Reserve’s final and amended capital plan and  stress test rules, and Federal Reserve policies and procedures about how  it has implemented and used DFAST and CCAR in its supervision of  banking institutions.
Why GAO Did This Study

The Federal Reserve has two stress test programs for certain banking institutions it supervises. DFAST encompasses stress tests required by the Dodd-Frank Act. CCAR comprises a qualitative assessment of firms' capital planning processes and a quantitative assessment of firms' ability to maintain sufficient capital to continue operations under stress. Questions have been raised about the effectiveness and burden of requiring two stress test programs. GAO was asked to review these programs and their effectiveness. This report examines how the stress test programs compare, the CCAR qualitative assessment, and the design of the stress test scenarios and models.
GAO analyzed Federal Reserve documents including rules, guidance, and internal policies and procedures on DFAST and CCAR implementation and assessed practices against federal internal control standards and other criteria. GAO also interviewed Federal Reserve staff and officials of 19 banking institutions selected based on characteristics such as their size, prior stress test participation, and history of CCAR results.

What GAO Found

The Board of Governors of the Federal Reserve System (Federal Reserve) has two related supervisory programs that involve stress testing but serve different purposes. Stress tests are hypothetical exercises that assess the potential impact of economic, financial, or other scenarios on the financial performance of a company. Stress tests of banking institutions typically evaluate if the institutions have sufficient capital to remain solvent under stressful economic conditions.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) implements statutory stress test requirements, known as the Dodd-Frank Act Stress Tests (DFAST) for Federal Reserve-supervised banking institutions with more than $10 billion in total consolidated assets. DFAST projects how banking institutions' capital levels would fare in hypothetical stressful economic and financial scenarios. It applies to a broad range of banking institutions and consists of supervisory- and company-run stress tests that produce capital adequacy information for firms' internal use and for public disclosure.
The Federal Reserve also conducts a Comprehensive Capital Analysis and Review (CCAR), which uses DFAST information to assess the capital adequacy (a quantitative assessment) and capital planning processes (a qualitative assessment) for bank holding companies with total consolidated assets of $50 billion or more. CCAR generally does not require additional stress tests and uses the same data, models, and projections used for DFAST.
While the primary purpose of DFAST is to produce and disclose comparable information on the financial condition of banking institutions (the stress test results), the Federal Reserve uses CCAR to make supervisory assessments and decisions about the capital adequacy plans (including proposed capital actions such as dividend payments) of large bank holding companies. For example, the Federal Reserve may object to a company's plan if stress test results show the company's post-stress capital ratios (regulatory measures that indicate how much capital is available to cover unexpected losses) falling below required minimum levels or if the Federal Reserve's qualitative assessment deems the firm's capital planning and related processes inadequate. An objection can result in restrictions on a firm's capital distributions. Several of the companies GAO interviewed that are subject to Federal Reserve stress tests identified benefits from the tests (such as overall improvements in risk management and capital planning) and also identified costs (including for staff resources and other expenditures necessary to conduct the tests and meet the Federal Reserve's supervisory expectations).
GAO found limitations in the Federal Reserve's stress test programs that could hinder their effectiveness.
Qualitative assessment disclosure and communication. The Federal Reserve uses a framework with multiple levels of review to assess qualitative CCAR submissions that helps ensure consistency, but it has not disclosed information needed to fully understand its assessment approach or the reasons for decisions to object to a company's capital plan. Transparency is a key feature of accountability and such incomplete disclosure may limit understanding of the CCAR assessments and hinder public and market confidence in the program and the extent to which the Federal Reserve can be held accountable for its decisions. Federal internal control standards state the importance of relevant and timely communications with external stakeholders. The Federal Reserve has not regularly updated guidance to firms about supervisory expectations and peer practices related to the qualitative assessment. For example, it has not published observations of leading capital planning practices used in CCAR since 2014. The limited communication can pose challenges to companies that must meet these expectations annually and could hinder the achievement of CCAR goals.
Scenario design. The Federal Reserve has a framework for designing stress test scenarios but its analysis of some key design decisions has been limited. For example, the Federal Reserve has not conducted analyses to determine whether the single severe scenario it uses for the supervisory stress test is sufficient to accomplish DFAST and CCAR goals. While there are advantages to using one scenario—including simplicity and transparency—many different types of financial crises are possible, and the single selected scenario does not reflect a fuller range of possible outcomes. Without additional analysis, the Federal Reserve cannot be reasonably assured that banks are resilient against a range of future risks. The Federal Reserve also has not explicitly analyzed how to balance the choice of severity—and its influence on the resiliency of the banking system—with any impact on the cost and availability of credit, which could limit its ability to avoid undesired economic effects from scenario design choices.
Model risk management. Federal Reserve supervisory guidance for banking institutions states that risk from individual models and also from the aggregate system of models should be managed. The Federal Reserve makes supervisory decisions based on the results of its own stress test models, but its management of model risk—the potential for adverse consequences from decisions based on incorrect or misused model outputs—has not focused on its system of models that produce stress test results. To estimate the effect of stress test scenarios on companies' ability to maintain capital, the Federal Reserve has developed individual component models that predict a company's financial performance in the scenarios. The results of these component models are combined with assumed or planned capital actions of companies and form the system of models used by the Federal Reserve. The Federal Reserve has an oversight structure for developing and using models in the supervisory stress tests but its own risk-management efforts have not targeted the system of models. For example, it has not conducted sensitivity and uncertainty analyses—important elements in the Federal Reserve's model risk management guidance—of how its modeling decisions affected overall results. Without such a focus, the Federal Reserve's ability to effectively evaluate and manage model risk and uncertainty from the entire system of stress test models will be limited. Understanding and communicating this uncertainty is critical because the outcome of the CCAR assessment can have significant implications for a company, including limiting its capital actions (such as dividend payments and share repurchases).

What GAO Recommends

GAO is making 15 recommendations to help improve the effectiveness of the Federal Reserve's stress test programs, such as improving disclosures and communications to firms, considering the potential consequences of its scenario design choices, and expanding model risk management to include the entire system of models. The Federal Reserve generally agreed with the recommendations and highlighted select ongoing and future efforts.