On June 21, the Federal Reserve released the results of the 2018 Dodd-Frank Act Stress Tests (DFAST). In this blog post, we assess the implications of these results through the lenses of two notice of proposed rulemakings currently out for public comment, namely the proposal to establish a stress capital buffer (SCB) framework and the proposal to revise the enhanced supplementary leverage ratio (eSLR) applicable to global systemically important banks (GSIBs).
The SCB proposal would integrate the capital requirements under the stress tests with the “point-in-time” requirements under the Basel III rule. This proposal would effectively reduce the number of capital requirements from eighteen to eight, including the elimination of the post-stress supplementary leverage ratio (SLR) requirement. In theory, this would be an improvement over the existing framework because the reduction in the number of capital requirements would likely reduce the complexity of the current regulatory capital regime and lead to improvements in capital planning at banks. The proposal also would replace the uniform 2.5 percent capital conservation buffer with a bank-specific stress capital buffer.
The eSLR proposal is designed to make the leverage ratio requirement less binding for the largest U.S. banks. This is important because there is widespread empirical evidence indicating that binding risk-insensitive capital ratios incentivizes banks to shift their portfolios toward riskier assets. Lastly, as noted in a previous TCH research note, the 2018 severely adverse scenario features a downturn in the U.S. economy that is significantly more severe than previous years’ stress scenarios and the 2007-2009 financial crisis. Therefore, capital requirements were expected to increase due to the increased severity of the 2018 stress scenario.
The key takeaways from this yesterday’s DFAST results are as follows:
- Based on DFAST 2018 results, banks’ proposed stress capital buffers would rise 90 basis points in aggregate, from 3.0 percent (using DFAST 2017 results) to 3.9 percent. For the GSIB group, the aggregate SCB rose 110 basis points, namely from 3.2 percent to 4.3 percent.
- The increase in capital requirements is likely to dampen loan growth at banks subject to the stress tests and reduce economic growth had the SCB been calculated using this year’s results.
- As a result of the increase in the SCB under the Fed’s proposal, the total amount of excess capital (the amount by which their capital exceeds the proposed requirements) at banks subject to the stress tests would decline approximately $85 billion, namely from $205 billion to $120 billion.
Figure 1 shows the average stress capital buffer using DFAST 2017 and DFAST 2018 results for the following three bank groups: (1) all DFAST banks; (2) GSIBs only; and (3) non-GSIBs. We estimate the SCB proposal would increase 90 basis points in DFAST 2018 on average across all banks. The increase is mainly driven by an increase in projected loan losses, trading and counterparty losses, and operational risk losses. The increase also reflects a decline in other comprehensive income (OCI) in DFAST 2018 relative to last year’s exercise driven by unrealized gains and losses in securities. The increase in losses and OCI reflects the increase in severity in this year’s stress scenario, which also featured higher longer-term Treasury yields in contrast to past years (lower OCI). In addition, the U.S. tax reform enacted this year had a negative material impact on some banks’ post-stress ratios.
Figure 2 plots the amount of excess capital at DFAST banks for the same three groups of banks. The amount of excess capital is defined as the minimum amount of capital in excess of the most binding regulatory capital requirement across the eight capital requirements listed in the SCB proposal.  As shown in the chart, the amount of excess capital would decline approximately $85 billion, with the GSIB group accounting for more than 80 percent of the change. The amount of excess capital for the non-GSIB group would decline $15 billion in DFAST 2018 relative to last years’ exercise. In previous research, we demonstrated that excess bank capital is an important determinant of economic growth.
The Fed’s SCB proposal reduces the number of capital requirements from eighteen to eight. Our analysis is based on the eight regulatory capital ratios under the SCB proposal. However, the SCB as defined in the Fed’s NPR proposal is not readily available and needs to be estimated using DFAST results published by the Federal Reserve. This post uses DFAST results from the 2017 and 2018 stress testing cycles. To evaluate the size of the stress capital buffer and the amount of excess capital for each bank, we estimated the SCB under the same assumptions as those defined in the Fed’s NPR. This is done by calculating the peak-to-trough decline for each regulatory capital ratio under the nine quarter stress horizon. This estimate is then adjusted to use fully phased-in regulatory capital ratios instead of ratios under the transitional arrangements and removes the impact of balance sheet growth on regulatory capital ratios. In addition, it includes only the requirement to prefund dividends over 4 quarters. We have also modified the adjustment for balance sheet growth and dividend payouts whenever the trough in regulatory capital ratios occurs before quarter 9 in the stress horizon.
 The eight regulatory capital requirements included in the SCB proposal includes six risk-based ratios and two non-risk based ratios. The six risk-based ratios include the common equity tier 1 ratio, the tier 1 capital ratio and the total capital ratio under the standardized and the advanced approaches (based on banks’ own internal models). The two non-risk based ratios include the tier 1 leverage ratio and the supplementary leverage ratio.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.