BPInsights: June 24, 2023

Previewing the Fed’s Latest Stress Test Results

The Federal Reserve will unveil the results of its 2023 stress test on June 28. The results determine large banks’ stress capital buffer, a significant part of their capital requirements. Here’s what BPI’s head of research expects from the results.

  • The key metric of the stress test—the trajectory of the aggregate common equity tier 1 (CET1) capital ratio over the projection horizon—is projected to decline from an initial 12.4 percent to a minimum of 9.2 percent. The 3.2-percentage-point decline in this year’s test surpasses the 3.0-percentage-point decrease in the 2022 stress test for the same set of banks.
  • As a result, banks’ capital requirements will likely rise due to this year’s stress tests. The stress test scenario for this year is more severe, featuring a greater increase in the unemployment rate and a larger, faster decline in house prices. The scenario continues to assume a significant drop in commercial real estate prices. Offsetting some of the intensified severity, banks using the “advanced approaches” will see an increase in the fair value of their available-for-sale securities, mitigating some of the declines in regulatory capital under stress.
  • Furthermore, slightly lower trading and counterparty losses for banks with substantial trading, processing or custodial operations are also expected.
  • Of note, stress test results are likely to be underestimating banks’ revenue under stress due to the lack of model updates.

Worth noting: In a departure from standard practice, the Fed has not released any updates to its stress testing methodologies this year. It’s still unclear whether this year’s Fed stress test results disclosure will shed light on any methodology changes. Without major revisions to account for changes in the composition of banks’ assets and financial performance, the Fed’s models will likely keep generating overly high noninterest expenses. It’s important for stress test methods to be adjusted as bank balance sheets, earnings and regulations evolve, and for the Fed to clearly communicate such adjustments to banks and the public so they can understand how the Fed forecasts risks in the banking system.

Why it matters: The details of the stress tests drive banks’ capital requirements, which ultimately affect borrowing costs for households and businesses.

Five Key Things

1. Circle, Chinese Tech: The Biggest Beneficiaries of SVB’s Deposit Rescue

Big Tech and venture capital firms – stablecoin issuer Circle, a venture capital giant and a Chinese technology firm among them – were the top depositors at SVB, benefiting from the government’s backing of the bank’s uninsured deposits. Here are the top 10 depositors, according to a Bloomberg report citing an FDIC document:

  1. Circle Internet Financial ($3.3 billion in deposits)
  2. SVB and parent company ($4.6 billion)
  3. Sequoia Capital Fund ($1.0 billion)
  4. Kanzhun Limited ($903 million)
  5. Bill.com LLC ($761 million)
  6. Altos Labs ($680 million)
  7. Marqeta ($635 million)
  8. Roku Inc. ($420 million)
  9. IntraFi/Promontory ($411 million)

The FDIC has proposed a special assessment on banks to recover the costs of covering these uninsured deposits.

2. FDIC’s Gruenberg Signals Closer Scrutiny of $100B-$250B Banks

FDIC Chair Martin Gruenberg offered insights in a recent speech on the upcoming proposed rule implementing the revised 2017 Basel agreement in the U.S. Here are some key takeaways.

  • Size threshold: Gruenberg noted that the banking agencies are considering applying the proposed rule to banks with assets over $100 billion, echoing recent comments by Federal Reserve Vice Chair for Supervision Michael Barr. “This consideration has certainly been influenced by the recent experience with three bank failures of institutions with assets between $100 billion and $250 billion,” Gruenberg said. “If we had any doubt that the failure of banks in this size category can have financial stability consequences, that has been answered by recent experience.” (Fed Chair Powell indicated in Congressional testimony this week that there may be capital increases for banks down to $100 billion in assets.)
  • What-if: Gruenberg speculated that if SVB’s losses on securities had been required to be recognized in capital, it might have averted the loss of market confidence that sparked the run on the bank. “That is because there would have been more capital held against these assets,” he said.
  • Leverage capital requirements: Gruenberg rejected the idea that leverage capital requirements could be lowered to counterbalance higher risk-based capital requirements. “It was an essential post-crisis reform that must not be weakened,” he said.
  • Higher capital: “This phase of Basel III is expected to increase risk-based capital relative to the risks I just described,” Gruenberg said, referring to market risk, operational risk, credit risk and risks associated with derivatives. In a Q&A session, Gruenberg pushed back on the fact that higher capital requirements constrain lending and economic growth and shift financing into the shadow banking sector.

3. Op-Ed: Higher Capital Isn’t Free

Raising capital requirements has real costs, including pressure on financial stability, former House Financial Services Committee Chair Jeb Hensarling wrote in a recent Wall Street Journal op-ed with Michael Solon. Monetary tightening, persistent inflation, Treasury’s major borrowing plans amid market liquidity strains and other factors are already encircling the U.S. economy, yet “[i]nto this cauldron, bank regulators want to add a credit-tightening increase on capital standards,” Hensarling and Solon wrote. The authors note that large U.S. banks already hold significant amounts of capital and that U.S. regulators have acknowledged this strength. “Mandatory higher capital requirements aren’t free,” the two wrote. “They impair bank lending. Now isn’t the time to do that.”

4. Bank Regulation is Front and Center at Fed Hearings

Federal Reserve Chair Jerome Powell testified this week at House and Senate hearings. Bank regulation dominated the discussion. In addition to capital, Powell also discussed CBDC, the FedNow payment system and stablecoins. This week, nominees to the Fed’s Board of Governors – Philip Jefferson, Lisa Cook and Adriana Kugler – also faced questions from the Senate Banking Committee. Here are some notable comments.

  • Tradeoffs: Powell acknowledged the tradeoff in setting capital requirements. “With capital standards, it’s always a tradeoff,” he said to Rep. Young Kim (R-CA), who expressed concern about small businesses’ access to financing. “The more capital means more stable, more sound, more resilient banking system, but it also at the margin can mean a little bit less credit availability and also the price of credit can be affected and there’s no perfect way to assess that balance.” “Excessively high capital requirements will constrain credit provision to the economy, costing jobs, incomes, opportunities and living standards,” Rep. Mike Lawler (R-NY) said.
  • “Exactly the right question”: At the nomination hearing, Sen. Mark Warner (D-VA) also expressed concern, stating that making changes to capital at a time when the Fed is also working to control inflation could decrease access to credit at a critical economic moment. Responding to a similar concern expressed by Rep. Lawler (R-NY) at the HFSC hearing, Powell shared his view that “capital requirements [do not] play into the near-term economic situation the way interest rate hikes do,” and noted in this regard the length of the comment period, lag between rule proposal and finalization, and “long” phase-in period. However, in response to Rep. Zachary Nunn (R-IA) at the House hearing, Powell said he expects banks will begin to adjust as soon as the proposal is released. “It’s not an absolute thing where they’ll wait until the effective date,” he said. Separately, Banking Committee Ranking Member Tim Scott (R-SC) asked Powell at the Fed chair’s hearing: “Over the last decade, it seems that capital is continually being raised. My question is: how much is too much and when is enough enough?” “I think that’s exactly the right question,” Powell told Scott. “There is a tradeoff between making the banks safer, secure, more resilient—you want them to be very strong, particularly the largest banks, so that they can continue to intermediate and lend money and things like that, continue to function even during stressful situations. But, with bank capital, it’s always going to be a trade-off between the availability and cost of credit and how much safety and I think that’s the question that we’re going to be addressing and answering.”
  • Size: Powell noted that “any increase in the capital for the large banks would need to be justified” at the House hearing. “I don’t think there will be much in the way of capital increases proposed for banks other than the very large banks, but we’ll have to see.” Powell said at the Senate hearing that “there may also be some capital increases in the proposal for banks down to $100 billion, but not below that.”
  • Global view: Rep. French Hill (R-AR) asked Powell if the U.S. Global Systemically Important Banks were better capitalized than their Asian or European peers. “We’re certainly at or near the top of the league table,” Powell said.
  • Distractions: At the nomination hearing, Sen. Bill Hagerty (R-TN) warned against the Fed using the Basel agreement as a “backdoor” way to make ideological changes that do not support bank safety and soundness.
  • Supervisory culture: Rep. Nydia Velazquez (D-NY) asked Powell about the purported change in supervisory culture described in the Barr report on SVB, focusing on the tenure of Vice Chair for Supervision Randal Quarles. Powell said that the dynamic Velazquez described was not how he remembered things, and that he recalled Quarles encouraging examiners to focus on the most important risks.
  • Real stress test: Rep. Andy Barr (R-KY) said Vice Chair for Supervision Michael Barr’s impending “holistic” capital review is unnecessary given banks’ resilience during COVID. The lawmaker called for oversight of “new, onerous one-size-fits-all regulation by the Fed.”
  • Supervision: Sen. Thom Tillis (R-NC) asked Powell to identify who was responsible for supervision of SVB. Powell said ultimately, “the buck stops with the Board” of the Federal Reserve. Powell also said liquidity regulation needs an update because the liquidity coverage ratio and net stable funding ratio are “just not adequate to a world where people are moving money around on their phones like that.” He also said that the supervisors at the San Francisco Fed did not engage in the kind of behavior that warrants termination.
  • Discount window stigma: Sen. Warner (D-VA) raised the issue of stigma around the Fed’s discount window and suggested that banks’ willingness to use it could mitigate the risk of tech-enabled bank runs. “It’s critically that people be able to use and willing to use the discount window and also the Bank Term Funding Facility,” Powell said. He also said “it’s good that banks have been willing to use the discount window and the new facility during this crisis.” Warner noted the possibility that banks may be scrutinized by regulators or examiners for using the window.
  • Process: At the Powell hearing, Sen. Hagerty (R-TN) questioned whether Fed officials will have enough time to fully consider the details of the Basel proposal, which will likely be long and complex. Hagerty noted that Fed Governor Lisa Cook said in a separate hearing that she had not yet reviewed it, and said “my understanding is that the agencies, including the Fed, are due to vote on this on the 18th of July.” Powell said he would ensure the governors have enough time to carefully evaluate the proposal, that the staff has been briefing them and that the “proposal is still evolving.”

5. CLF Notes: What is a Committed Liquidity Facility?

A type of central bank lending new to the U.S. may be the key to balancing heightened liquidity needs with banks’ financing of the economy. A new BPI note explains what Committed Liquidity Facilities are and how they could be offered in the United States. CLFs are lines of credit sold to banks by the Fed for a fee, collateralized by loans to businesses and households. They would enable banks to become more liquid without shifting even more of their balance sheets into loans to the government and away from loans to the real economy.

In Case You Missed It

DOJ’s Antitrust Review of Bank M&A Could Get More Bespoke, Granular – and Uncertain

The Department of Justice will consider a broader set of factors in evaluating bank M&A, Assistant Attorney General Jonathan Kanter said in a speech this week. In drawing a comparison to the DOJ’s longstanding practices in its competition review, the Antitrust Division chief indicated that the DOJ will consider a myriad of factors beyond concentration of bank deposits and branch overlaps. “Rather, a competitive factors report should evaluate the many ways in which competition manifests itself in a particular banking market—including through fees, interest rates, branch locations, product variety, network effects, interoperability, and customer service,” Kanter said. “Our competitive factors reports will increasingly address these dimensions of competition that may not be observable simply by measuring market concentration based on deposits alone.” DOJ will scrutinize deals that “increase risks associated with coordinated effects and multi-market contacts”, he said. It will also consider how a potential merger affects customer choices in different lines of banking business.

  • Remedies: Kanter signaled that the DOJ will be much less amenable to providing negotiated settlement agreements to the banking agencies as selling off branches may not suffice to address all DOJ’s competitive concerns, including “interoperability and network effects”.  The DOJ will instead narrow its focus to providing advisory opinions to the banking regulators, while reserving DOJ’s authority to challenge a merger in court following an approval from the banking agencies. 
  • What it means: Kanter characterized these steps as a revamp of DOJ’s approach to bank M&A analysis. He indicated that the framework, last updated in the 1990s, is due for an overhaul. But a more bespoke, granular approach could mire the already fraught M&A application process in delays, confusion and uncertainty.
  • Next steps: DOJ expects to release revised bank merger guidelines in coordination with the banking agencies. It is still unclear when that will occur, but Kanter’s remarks may well give a preview of what is to come.

‘Reverse’ Stress Tests, New Talent: Barr’s Vision for Updated Bank Supervision 

Federal Reserve Vice Chair for Supervision Michael Barr outlined ways the Fed could potentially revamp bank supervision, including “reverse stress tests” of bank resilience possibly hiring behavioral scientists to bring a “multidisciplinary lens” to the field. “We are going to conduct a project that looks system-wide at areas where we can enhance our supervisory culture, behavior, practices and tools, and also where we need to change regulation over the next six months,” Barr said at a New York Fed conference. A reverse stress test would consider what stressors could bring a bank down, he said. “Instead of thinking about a stressful scenario and then seeing how it plays through … you look at the bank and say, ‘What would it take to break this institution?’”

  • Context: The Fed’s upcoming look at its supervisory culture comes in the wake of SVB’s failure. Barr’s April report on SVB blamed a lax supervisory culture under his predecessor as a key factor in the bank’s failure, but the raw materials in that report depict a supervisory approach that was both active and assertive, just not on the core risks that toppled the bank.

Bank of England Launches ‘Exploratory Scenario’ Exercise 

The Bank of England recently launched its first “system-wide exploratory scenario exercise” to explore banks’ and nonbanks’ behaviors under stress and how those behaviors interact to amplify market shocks. The firms participating in the exercise include large banks, insurers, hedge funds and pension funds, among others.

  • Context: The Bank points to recent market meltdowns such as the U.K. gilt market turmoil in September 2022 and the “dash for cash” in March 2020 as examples of sudden liquidity stresses amid market volatility. Such episodes presumably inspired the exercise.
  • Goals: The exercise is not a test of the resilience of the institutions like a capital stress test, but instead aims to understand the risks surrounding nonbank financial firms and the behavior of banks and nonbanks under stress. It also aims to investigate how these behaviors and market dynamics can amplify shocks in financial markets and present risks to U.K. financial stability.

Discount Window, Supervision: NY Fed’s Top Lawyer Weighs in on SVB

Richard Ostrander, general counsel of the Federal Reserve Bank of New York, gave a recent speech discussing the Fed’s Bank Term Funding Program and lessons for supervisors from SVB. Here are some key takeaways.

  • BTFP: Ostrander sheds light on the making of the BTFP, the lending program formed in response to SVB’s failure. The program aimed to support financial stability by providing financing to banks with large unrealized losses on their securities. The Fed had no time during the chaotic SVB failure weekend to set the program up like a pandemic lending program with special-purpose vehicles, and traditional discount window operations “could not fully meet the acute needs of the banking sector,” Ostrander said. Among other issues, the section of law that authorizes Fed discount window lending does not allow reserve banks to lend for a period longer than four months. So the Fed turned to Section 13(3) of the Federal Reserve Act, which authorizes specialized lending in emergencies. Ostrander also laid out the Fed’s thinking on collateral options: “By limiting eligible BTFP collateral to essentially Treasury and Agency securities, the BTFP was targeting issues arising from interest rate-driven mark-to-market losses,” Ostrander said. “Allowing other forms of collateral would have potentially introduced questions about the credit or underwriting of the collateral, which would have unnecessarily complicated and increased the risks of the program.”
  • Prepared: The failure of Signature Bank in particular revealed the danger of being unprepared to borrow from the Fed’s discount window, Ostrander said. “Though we tailored a solution under these circumstances, banks would be very unwise to assume the Fed will be able to provide special, individualized attention and creative solutions in the event of another liquidity crisis,” he said. “Bank management must take ownership of their operational preparedness before a liquidity crisis occurs.” Banks should identify gaps in their capabilities through tabletop exercises and refamiliarize themselves with how to access the discount window. “I urge banks to take the extra step of exercising these borrowing capabilities regularly to facilitate access to funds should the need arise,” he said. He also said overcoming discount window stigma would benefit banks and their customers.
  • Supervision: Ostrander noted the importance of bank management decisions as a factor in bank failures. “Regulators and supervisors can minimize the impact and probability of bank failures, but they cannot prevent all banks from failing,” he said. “The decisions of bank managers will ultimately play the most important role in determining the success or failure of a given bank.” He expressed alarm that, during a Senate hearing, the former SVB CEO appeared to downplay the urgency of a Matter Requiring Attention. “The fact that an issue becomes a supervisory finding at all means it is important!” he said. He warned that bank management can become inured to the seriousness of supervisory findings, “especially where they are allowed to linger without consequences.” He suggested stronger follow-through from supervisors, including more specific timelines for addressing MRAs and MRIAs; clear expectations about the consequences if matters aren’t resolved on time; and cracking down if supervisory issues linger.

The Crypto Ledger

BlackRock applied to launch a bitcoin ETF in news that shook the crypto ecosystem. Here’s what’s new in crypto this week.

  • Likely targets: Now that the SEC has set its sights on Coinbase and Binance, who’s next? One report suggests stablecoins, namely USD Coin and Tether, could be the next target of regulatory scrutiny.
  • In the U.K.: Legislation to recognize crypto as a regulated activity has advanced in the U.K. Parliament. The House of Lords approved the Financial Services and Markets Bill on Monday, sending the bill one step closer to becoming law. The bill includes provisions on regulating stablecoins under U.K. payments rules and measures to supervise crypto promotions.

BNY Mellon Teams Up with Black-Owned Fintech MoCaFi to Reach Unbanked Customers

BNY Mellon is partnering with MoCaFi, a black-owned financial technology platform, to enable payments for unbanked consumers. The service will offer customers a safe and affordable payment option as an alternative to costly check cashers.

 

Next Post: BPInsights: February 17, 2023 View Next Post


Disclaimer:

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.