July 31, 2020
Amid the current, unprecedented downturn, a regulatory regime imposed in the previous one is still very much in force. The Dodd-Frank Wall Street Reform and Consumer Protection was released in late July of 2010, and Trepp’s Matt Anderson and Maximilian Nelson note that 10 years on, “the foundations behind the bill are still in place” even as some of the Dodd-Frank regulations have been reversed.
In fact, Anderson and Nelson write, the financial stress testing protocols that Dodd-Frank established have come to the fore in recent months. “Trepp has received more inquiries for its suite of stress testing products since the year began,” they point out.
This uptick in inquiries bolsters Trepp’s belief that regulators “have stepped up their interest in banks’ modeling and stress testing capabilities. This concern seemed to have increased prior to the onset of COVID-19 and the pandemic-induced economic downturn, but has picked up further in recent months.”
One are of particular interest is commercial real estate loan stress testing. “Regulators want to be sure that banks are scrutinizing individual loans throughout the loan portfolio, to identify and mitigate potential risks, and to quantify the potential for loss,” according to Anderson and Nelson. “By modeling defaults and losses under alternative scenarios, lenders can get a sense of which loans or groups of loans pose the greatest risk of loss.”
Additionally, regulators lately have scrutinized banks’ capital adequacy analysis. If loan losses accumulate, “they could drive capital ratios below minimum thresholds and put banks at risk of being shut down,” Anderson and Nelson write.
“Capital adequacy stress testing requires banks to simulate the performance of the entire bank under a stress scenario: earnings, balance sheets, loan losses, and capital are all put under the microscope and examined,” they note. This scrutiny extends to smaller banks that aren’t required to undergo stress tests under Dodd Frank.
In recent CRE webcasts, the point has been made time and again that a key difference between the current, health crisis-driven downturn and the 2008 Great Recession is that the debt markets are in far better shape today. Anderson and Nelson say Dodd-Frank has been a significant contributor to financial institutions’ relatively firm footing.
“Banks continue to operate in conditions that are not conducive to growth or economic success, and regulators have tightened their standards, but foresight and required planning have allowed them to come through the current pandemic without risk of the type of collapse felt during the 2008 crisis.”
For comments, questions or concerns, please contact Paul Bubny