BPInsights: February 24, 2024

Deep Dive: DFAST 2024 Stress Test Scenarios

The Federal Reserve on Feb. 15, 2024, released the scenarios for this year’s stress tests. These include:

  • The severely adverse scenario and global market shock component, which are used to calculate large banks’ stress capital charge. The former evaluates a bank’s ability to withstand a severe macroeconomic recession and is designed to set a bank-specific capital buffer. The latter is imposed on banks with major trading operations and results in additional losses that feed into the bank’s stress capital charge.
  • Four additional exploratory scenarios to evaluate banks’ resilience to funding stress combined with rising interest rates and a global recession. The results of these scenarios will not be used to calculate a capital charge and the Fed will only release the aggregate results.

How it works: Banks’ stress capital charges are determined by the decline in each bank’s common equity tier 1 capital ratio under the severely adverse scenario, including the market shock for banks with large trading operations. A larger decline in a bank’s capital ratio results in a higher stress capital charge. Failure to maintain the required level of capital severely restricts a bank’s ability to distribute capital to shareholders.

This year’s scenario: Overall, the 2024 stress scenario appears to be somewhat more severe than last year’s scenario, especially with respect to the assumed path of equity prices and corporate bond spreads. In addition, some of the GMS risk factors are more severe than last year’s scenario. While many banks begin the exercise with a robust level of net interest income, potentially mitigating the heightened stress severity, the initial higher level of noninterest expenses could offset the anticipated improvement in pre-provision net revenue in this year’s stress tests. Like last year, banks are expected to see an increase in the fair value of their available-for-sale securities driven by the decrease in interest rates in the severely adverse scenario.

BPI projections suggest that this year’s stress test will result in a slightly higher reduction in projected bank capital ratios than last year’s stress test for banks in Categories I through IV. The greater severity of market shocks and a rise in provisions for loan and lease losses drive the higher aggregate decline in banks’ capital ratios.

Worth noting: The FDIC’s special assessment imposed in the fourth quarter of 2023 marks a unique aspect of this year’s stress tests. The models employed by the Federal Reserve often extend past data into future projections. Without an adjustment for the one-time FDIC charge in initial noninterest expenses for banks, bank capital requirements could be overstated. It would therefore be more reasonable for the Federal Reserve to exclude this FDIC charge from noninterest expenses at the start of this year’s stress tests when generating the projections of bank performance over the nine-quarter planning horizon.

Exploratory scenarios: BPI analysis of the exploratory scenarios suggests the second exploratory macroeconomic scenario might lead to larger reductions in banks’ CET1 capital ratios compared to the severely adverse scenario as the difference in severity between the severely adverse and the second exploratory scenarios is small. In addition, the inclusion of funding stresses and higher unrealized losses on available-for-sale securities could result in greater capital drawdowns in that scenario for some banks. The impact of the default of the five largest hedge fund exposures, as opposed to the current assumption about the default of the largest counterparty, is also a novel feature of the exploratory scenarios and the effect on counterparty losses remains uncertain.

It is yet to be determined how the Federal Reserve plans intends to use the results of the exploratory scenarios and how these findings will inform supervisory evaluations of firms’ risk management practices.

Five Key Things

1. Paper: The Potential Costs of the Basel Proposal

A recent paper by University of Chicago Economics Professor Randall Kroszner examines the potential costs and consequences of the banking agencies’ Basel proposal. Here are some key takeaways from the paper.

  • Large U.S. banks are well-capitalized in the wake of post-Global Financial Crisis regulatory changes.
  • The proposal’s market risk component overlaps with the Global Market Shock in the Federal Reserve’s stress tests.
  • The proposal’s unintended consequences include increased costs for pension funds, low-income and minority borrowers, green energy investments and other “end users” of bank products and services.
    • The proposal may also generate higher costs for hedging and lower liquidity that could increase market volatility.
    • Reduced investment as a result of the proposal can lead to lower productivity, reducing workers’ wage growth and overall economic growth.
    • The proposal could drive a shift of financing and other activities from banks to nonbanks.
  • The proposal contains “only a very broad qualitative assessment” of its economic impact and no specific analyses on which that assessment is based, in contrast to the Bank of England’s approach.

2. Fed’s Bowman: ‘Hopeful’ for Basel Compromise

Federal Reserve Governor Michelle Bowman this week said she is “hopeful” that the Fed can reach a compromise on the Basel proposal that garners broad support, but such a compromise would require significant changes. “There are so many impacts of Basel that I hope can be addressed, whether it’s in a new proposal or within a very significantly amended version of the proposal that was passed by the board last summer,” Bowman said at the Exchequer Club of Washington on Wednesday. She said any final rule would need to change the treatment of operational risk and preserve regulatory tailoring.

  • Barbell effect: Bowman warned of a “barbell effect” where banks must be either much smaller or much larger than the regulatory threshold of $100 billion in assets in order to thrive.

3. Banks Support National Strategy to Identify Opportunities and Barriers to Financial Inclusion

BPI, the American Bankers Association and Consumer Bankers Association made recommendations this week to the U.S. Department of Treasury in response to its request for information to inform its establishment of a nationwide financial inclusion strategy. The percentage of consumers with access to banking account services is at historic highs and significant progress has been made to help all Americans realize the benefits of banking access. Banks are continuing to support this success by investing in a wide range of activities to serve consumer needs.

“Banks are committed to making financial services accessible to all Americans and value the opportunity to partner with regulators to identify opportunities to overcome barriers to achieve that goal,” stated the Associations. “A national financial inclusion strategy should acknowledge the substantial industry contributions already underway and support these efforts by proactively addressing regulatory obstacles impeding future progress.”

An example of some of the efforts underway include:

  • Expanding access to low-cost transaction accounts through initiatives like “Bank On”
  • Investing in Community Development Financial Institutions and Minority Depository Institutions
  • Supporting small and minority-owned businesses through debt and equity capital investments
  • Partnering with state and local governments through programs such as Project REACh, aimed at improving credit underwriting practices
  • Speeding the availability of funds through real-time payments and peer-to-peer payment services

However, several regulatory actions threaten the success of these initiatives by imposing stringent new requirements on banks.

The consequence of these regulatory proposals could cause banks to reduce lending or reconsider product offerings.

  • Restricting banks’ lending abilities by requiring substantially higher capital requirements. Basel III endgame requires banks to hold significantly higher capital requirements, which risks limiting banks’ ability to offer mortgages, credit cards and small-business loans.
  • Imposing price caps on debit card interchange revenue. Changes to Regulation II, which limits what banks can charge merchants to cover the cost of processing debit card transactions, serve as a profitable handout to big-box retailers while reducing the amount banks can invest in low-cost checking accounts and fraud and scam prevention.
  • Eliminating incentives for customers to pay on time. Arbitrarily reducing the safe harbor on credit card late fees reduces incentives for customers to pay on time, which may lead to higher delinquencies that harm consumer credit scores. The reduced safe harbor would also make credit cards more expensive for consumers who pay their bills on time each month.
  • Stigmatizing banking services that customers value. Surveys have shown that customers overwhelmingly prefer paying an overdraft fee to having their payment declined. Efforts to eliminate these products risk forcing customers to use less-safe alternatives outside of the banking system, like payday, pawn and refund anticipation loans.
  • Failing to account for the role of nonbanks in financial services. Nonbanks play a significant role in financial services but are not subject to the same comprehensive, robust regulatory and supervisory framework that is applied to banks. Regulatory inaction in this space, as well as the decision not to apply important frameworks such as the Community Reinvestment Act to nonbanks, risks undermining the goals of financial inclusion.

4. OCC’s Hsu Eyes Risks from ‘Blurring’ of Banking and Commerce

Acting Comptroller Michael Hsu called in a speech this week for regulators to scrutinize financial system risks from “blurring” between banking and commerce. According to Hsu, the two areas most susceptible to “blurring” are payments and private credit and equity. Hsu referred to the patterns precipitating the Global Financial Crisis as an example of blurred lines between banking and commerce.

  • Rebundling: In payments, “the prospect of banking being rebundled by nonbank entities outside of the bank regulatory perimeter bears careful monitoring because of the financial stability implications,” Hsu said. Hsu described the notion of banking services – payments, lending and deposit-taking – being “rebundled” by a single fintech firm. Hsu has focused on risks of unbundling of payments in previous remarks.
  • Growing footprint: Hsu also noted the significant growth of private equity and credit. “The move by PE into private credit is notable because it involves nonbanks originating loans at scale and holding on to them—an activity traditionally done by banks,” he said.
  • Gaps: Hsu identified gaps in regulatory oversight, such as the lack of federal money transmitter licensing standards and the absence of consolidated supervision of private equity firms. Federal law limits deposit-taking to banks, but this restriction has not been used as a key tool in regulating “innovative deposit-like products,” he said.
  • Charter arbitrage: “Various fintechs have explored the possibility of obtaining a bank charter, seeking the benefits of a charter, such as cheaper funding and access to a Federal Reserve master account, while seeking to avoid its burdens, like consolidated supervision and the full panoply of regulatory requirements and supervisory expectations borne by traditional, full-service banks,” Hsu said. He pointed to examples of novel charters, such as Wyoming’s special purpose depository institution framework or industrial loan companies. “Rather than contort bank charters and blur banking and commerce … a better solution would be for Congress to create a federal framework for payments regulation,” Hsu said.
  • Trip wires: Hsu suggested a “trip wire” approach for the Financial Stability Oversight Council to ramp up scrutiny of risks that may endanger the financial system. “Trip wires” would trigger a closer look at such risks but would not be a “gotcha” system, he suggested. “The transparency it affords would provide clarity ex ante to companies or industries as to when they might be blurring banking and commerce,” he said.

5. Supreme Court Declines to Take Up Kirschner Syndicated Loan Case

The Supreme Court this week denied a petition to consider an appeal in the Kirschner v. JPMorgan case, leaving in place the Second Circuit decision that syndicated term loans are in fact loans not securities under the law. A Supreme Court reopening of the case could have upended the securities market, a key source of funding for certain U.S. businesses. The Court’s action marks the end of a thorny legal dispute over the status of syndicated lending.

In Case You Missed It

The Empire Strikes Back: How the Basel Proposal Would Shift Credit Allocation from the Private Sector to the Government

When someone applies for a loan, who decides if he gets it and at what rate? An under-appreciated result of the Basel proposal is how it would effectively shift the weight of that decision towards the government — and in a way rejected by the EU and UK. A new BPI blog post explains how.

One-size-fits-all: Most attention on the U.S. Basel proposal has focused on how it will significantly increase capital requirements, both as a whole and for particular asset classes. But something bigger is at stake: the proposal will determine who allocates credit, and will primarily assign that role to the government. Banks compete with one another on their ability to measure and manage risk, and consumers and businesses benefit from this competition, but the Basel proposal would undermine that thriving system by eliminating banks’ measures of credit risk from U.S. capital regulation. This would drive credit allocation decisions into a government framework of one-size-fits-all rules and secret models.

Background: The largest banks operate under the “advanced approach” to credit risk, with each bank modeling the risk of its loans based on both external data and internal loss experience, subject to regulatory limits, and using these models to determine appropriate risk weights for regulatory capital purposes. These models are backtested and verified to ensure accuracy. Such an approach is designed to be more granular and sensitive to differing risk levels of different assets. An alternative is the “standardized approach,” which does not differentiate between assets on a granular level. The risk weights in this approach are not based on data or actual loss experience and are not subject to backtesting.

  • Currently, the largest U.S. banks must calculate risk-weighted assets under both these approaches, and the standardized approach usually functions as the binding restraint. All other banks are subject only to the standardized approach.
  • The key compromise of the 2017 Basel agreement was to continue using banks’ own models for credit risk but enhance consistency by setting new limits on particular modeling choices and limiting how low a capital charge they could produce.

Global outlier: The U.S. Basel proposal goes in an entirely different direction from this compromise – and from other global banking centers — by eliminating the advanced approach to credit risk.

  • Only in the U.S., the largest banks also receive a stress capital charge based on the Fed’s annual stress test – this charge is based on granular models, but they are secret and not subject to oversight.
  • Evidence suggests the Fed’s models may produce inaccurate outcomes — for example, stress test results have varied significantly from year to year, even when the severity of the scenarios and the risk profiles of banks’ portfolios stayed similar.

The ramifications: The current Basel proposal would determine the capital requirements of banks operating in the U.S. based on a combination of crude standardized models and secret central-bank models. Bank customers and the public overall would lose the innovation, competitive benefits and expertise of private sector risk analysis and lack insight into government pricing of loans. Ultimately, capital would be misallocated in the U.S., and banks would have less incentive to invest in risk management.

The solution: The U.S. banking agencies should follow the rest of the world and retain the advanced approach for credit risk. And if the advanced approach is eliminated, then the Federal Reserve should provide notice and seek comment on all the models it uses to assess bank performance for purposes of its stress capital charge, as well as the process by which those models are combined to produce the charge.  Those Fed models would become the only granular, adaptable measures of credit risk at the largest banks for capital purposes. In addition to being good policy, transparency and public input is also required by law.

The Crypto Ledger

Here’s the latest in crypto.

  • New counsel: Convicted FTX founder Sam Bankman-Fried replaced his attorneys ahead of his sentencing, hiring Mark Mukasey as his new lead counsel. Mukasey also represents Alex Mashinsky, former CEO of bankrupt crypto firm Celsius.
  • Beyond borders: Do Kwon, the South Korean creator of stablecoin TerraUSD, should return to the U.S. to face trial, according to a court in Montenegro.

Capital One Agrees to Acquire Discover

Capital One Financial Corporation and Discover Financial Services this week announced that they have entered into a definitive agreement under which Capital One will acquire Discover in an all-stock transaction valued at $35.3 billion. “The transaction brings together two companies with long-standing track records of delivering attractive and resilient financial results, award-winning customer experiences, breakthrough innovation, and financial inclusion,” according to the companies.

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The views expressed do not necessarily reflect those of the Bank Policy Institute’s member banks, and are not intended to be, and should not be construed as, legal advice of any kind.