Fed’s Quarles Outlines Needed Adjustments to Stress Testing Framework

Fed’s Quarles Outlines Needed Adjustments to Stress Testing Framework

In a speech at the Brookings Institution this morning, Federal Reserve Vice Chairman Randal Quarles provided a comprehensive look at the Federal Reserve’s stress testing policy. His remarks included significant news; so also did remarks during Q&A on a broader set of topics.

Stress Testing

  1. The general framework of Federal Reserve’s proposed stress capital buffer will be finalized shortly. Although the SCB is not likely go into effect until the 2020 CCAR cycle, certain changes – e. g., more realistic assumptions about balance sheet growth—may be included for 2019.

Quarles: “Accordingly, I expect we will adopt a final rule in the near future that will settle the basic framework of the SCB, but re-propose certain elements. To enable this process to run its course, I expect that the first SCB would not go into effect before 2020. For 2019, I expect CCAR will remain in place for firms with over $250 billion in assets or that are otherwise complex; however, we will consider whether we can move forward with any aspects of the SCB proposal for CCAR 2019, such as assumptions related to balance sheet growth.”

  1. Consistent with the tailoring of enhanced prudential standards required under recent legislation (S. 2155), Vice Chairman Quarles suggested that banks with between $100 and $250 billion in assets would not be subject to CCAR in 2019, and presumably recommence in 2020.

Quarles: “I will also ask the Board to exempt firms with less than $250 billion in assets from the CCAR quantitative assessment and supervisory stress testing in 2019 in light of the every-other-year cycle contemplated in the tailoring proposal that the Board approved two weeks ago.”

  1. Reducing the year-to-year volatility of CCAR and the SCB remains a key focus, and will likely be the subject of forthcoming proposal. As part of this effort, the Fed will likely revisit the global market shock, and consider introducing multiple market shocks to improve its utility.

Quarles: “We are considering ways of preserving the dynamism of stress testing while reducing its volatility, and plan to seek comment on a proposal in this area in the not-too-distant future. In addition, we are also exploring ways of improving our approach to measuring risks in the trading book. Firms’ trading books are dynamic and complex, as firms hold both long and short positions. Many have noted that a single market shock does not adequately capture risks in firms’ trading book, and we agree with those comments. We are exploring ways to incorporate multiple market shocks in our stress test without adding volatility to the results and without increasing the compliance burden.”

  1. Under the Fed’s forthcoming capital framework, firms will soon know their stress losses (which become their stress capital buffer) prior to having to submit their capital plan. This is significant, as a major question raised by the Fed’s SCB proposal was whether its introduction of an ongoing capital requirement based on stress test results would be in addition to, or rather would replace, the current annual “pass-fail” component of CCAR. By noting that firms should know their SCB before they submit their capital plan for Federal Reserve review, Vice Chairman Quarles made clear that he believes it should be the latter, which would effectively end the annual CCAR quantitative objection process.

Quarles: “I will ask the Board to adjust the operation of the rule so that firms know their SCB before they decide on their planned distributions for the coming year.”

  1. The Fed is re-thinking the inclusion of four quarters of dividends in a firm’s SCB, but it remains unclear what the eventual result will be.

Quarles: “The SCB proposal would have included four quarters of dividends in a firm’s SCB, in recognition of the fact that firms experience market pressure to hold dividends constant, even under stress. In my view, there may be ways of encouraging greater reliance on less sticky repurchases while providing more flexibility in the regime, and we are exploring alternatives.”

  1. The Fed’s new capital framework is not likely to include a leverage-based measure, recognizing the conceptual incoherence of calibrating a leverage measure using a risk-based stress test methodology.

Quarles: “I am concerned that explicitly assigning a leverage buffer requirement to a firm on the basis of risk-sensitive post-stress estimates runs afoul of the intellectual underpinnings of the leverage ratio, and I would advocate removing this element of the stress capital buffer regime.”

  1. The Fed is likely to propose soon (via a policy statement) further transparency measures for CCAR, to begin in 2019. These will include release of some details of its models and hypothetical portfolios and loss rates, but still fall well short of actual disclosure of the Fed’s models.

Quarles: “I expect that soon you will see the Federal Reserve issue a policy statement describing governing principles around the supervisory stress testing process. As a part of that statement, I would expect a commitment to disclose additional detail about supervisory stress test models and results and to publish portfolios of hypothetical loans and associated loss rates.”

  1. The Fed will shortly propose to begin subjecting its annual CCAR scenarios to public notice and comment (which, as we’ve noted previously, is required under the Administrative Procedure Act). It is not clear whether this includes the standard by which the Fed will calibrate the scenario (currently, by policy statement, a scenario consistent with post-war U.S. recessions, though that standard has consistently been honored in the breach).

Quarles: “I expect that the Board will seek comment on the advisability of, and possible approaches to, gathering the public’s input on scenarios and salient risks facing the banking system each year. Such a proposal may also provide additional details about the scenario design features that underpins each year’s scenarios, and a range of other enhancements.”

  1. The CCAR qualitative objection, already eliminated for most banks in favor of standard supervisory processes, will likely be discontinued for all firms.

Quarles: “In my view, the time has come to normalize the CCAR qualitative assessment by removing the public objection tool, and continuing to evaluate firms’ stress testing practices through normal supervision.”

  1. Vice Chairman Quarles’s speeches continue to provide the public with delightful historical analogies and an expansive vocabulary. Here’s a quick glossary for today:
  • “In these circumstances, my discussing changes to our stress testing regime could sound uncomfortably close to the serene arrogance of Alfonso X of Castile, who famously said that ‘Had I been present at the creation, I would have given some useful hints for the better ordering of the universe.’” Alfonse X of Castile was a thirteenth-century king of Castile, Leon and Galicia in present-day Spain. Also known as “Alfonse the Wise,” he was also an avid poet and astrologer; the quote is thought to be in response to reading Ptolemy’s treatise on astrology.
  • (From Q&A) “We’ve always been at war with Eastasia.” Eastasia was one of three fictional superstates in George Orwell’s novel Nineteen Eighty-Four, occupying present-day China, Japan, Korea.
  • “Now, while [the requirement that a firm submit its capital plan before receiving its CCAR results] might at first blush appear to be pointless and obdurate cruelty, the reasoning behind the practice was initially perfectly sensible.” Merriam-Webster defines obdurate as “stubbornly persistent in wrongdoing” or “hardened in feelings.”
  • There was also a Star Trek reference, which we did not catch, but which caused a Trekkie in the audience to hoot with joy.

Additional Observations from Q&A after the Speech

  • Vice Chairman Quarles indicated his opposition to imposing a counterycyclical capital buffer. He stressed that the purpose of the buffer was financial stability and not macroeconomic management, and thus that a strong economy did not argue for the buffer; only rising financial stability risks would. In that context, he noted high bank capital and liquidity levels and assessed financial stability risks as generally moderate.
  • Vice Chairman Quarles acknowledged that the Volcker Rule was having effects on market liquidity, a fact about which prior Fed governors had expressed doubt.
  • In the context of stress testing transparency, he downplayed the notion that increased transparency was akin to “giving the banks the exam questions.” He said it was more akin to giving them “the textbook.” He stated that his greater concern about increased transparency was a concern about the potential concentration effects of a mono-model approach, as banks would tend to herd into favored assets, though he noted that banks are already reverse engineering the model based on each year’s results.
  • Asked about CECL, Vice Chairman Quarles referenced a forthcoming statement and indicated that there would be a study of the interrelationship of the accounting standard and regulatory capital. He stated that there was some debate about its day one impact, but notably said that there was less debate about its effect under stress, which he indicated would be procyclical.