How CFIs Can Maintain Adequate Capital in a Downturn

According to the National Earthquake Information Center, of the average 20K earthquakes that occur across the globe annually, more than a dozen result in extreme devastation. Collapsing buildings cause $2.1B in damage and lead to the loss of 10K lives each year. In 2021, to help mitigate the impact, University of California San Diego upgraded its Large High Performance Outdoor Shake Table — the first and largest shake table in the world. It enables seismic testing on large structural systems by reproducing multi-dimensional ground motions with unprecedented accuracy. This testing method has led to the development of safer structures that can withstand strong earthquakes.The results of a different kind of stress testing were released on June 23 by the Federal Reserve. The 33 participating banks passed the annual test with flying colors, proving they have “strong capital levels, allowing them to continue lending to households and businesses during a severe recession .” This year’s hypothetical scenario included a severe global recession, stress in commercial real estate and corporate debt markets, rising unemployment, and declining GDP. Despite projected total losses of $612B, large banks maintained an aggregate common equity capital ratio of 9.7%, double the required figure.This data effectively gives banking giants the go-ahead to distribute billions of dollars in excess capital via dividends and share buybacks, as most of them have already announced. Bucking the trend, JPMorgan Chase and Citigroup are keeping the payouts unchanged. “We will continue to use our capital to invest in and grow our market-leading businesses, pay a sustainable dividend, and we will retain capital to fully satisfy our future regulatory requirements,” said JPMorgan Chase CEO Jamie Dimon.Why CFIs should conduct stress tests
Although regulators don’t require community financial institutions (CFIs) to run stress tests to assess their capital adequacy, the federal banking supervisory agencies “emphasize that all banking organizations, regardless of size, should have the capacity to analyze the potential impact of adverse outcomes on their financial condition.” This is particularly encouraged for institutions with commercial real estate portfolios.CFIs can benefit from stress testing — whether at the transaction, portfolio, or enterprise level — in many ways, including enabling better strategic decision-making, improving risk management and capital planning, and enhancing the value of the institution.For example, consider a CFI with relatively strong capital, asset quality, and earnings performance. Stress testing could provide management with evidence of more than adequate capital levels, allowing for the distribution of excess capital through increased dividends, shareholder buyback plans, or a strategic acquisition. Conversely, a CFI in more distressed circumstances might benefit from the insights provided by stress testing to develop a plan to help fill the potential shortfall.How CFIs can ensure capital adequacy
As the demands for capital adequacy increases, it’s recommended that all CFIs establish and maintain a comprehensive capital plan. An essential element of a sound risk framework, a capital plan can enable an institution to better manage its capital reserves and reduce its dependency on raising extra capital from other sources.These four steps form the foundation of an effective capital planning process:

All financial institutions are expected to maintain adequate capital relative to their risk profile. A comprehensive capital plan that includes appropriate stress testing will go a long way to ensure long-term growth and resilience to adverse events.