Stress Tests and Improvements to the CCyB Framework

Stress Tests and Improvements to the CCyB Framework

In a speech on June 27, Eric Rosengren, President of the Federal Reserve Bank of Boston, called for consideration of raising the countercyclical capital buffer (CCyB).  The CCyB is an additional capital buffer that, under the Fed’s applicable regulation, can be added to the 18 largest banks’ capital requirements when the Federal Reserve Board sees an elevated risk of above-normal losses, particularly when there is rapid asset-price appreciation or credit growth that is not well-supported by underlying economic fundamentals.  The CCyB would provide these banks an additional layer of protection if a financial crisis were to take place.  In principle, the CCyB could also act as a brake on those building imbalances, but both the Basel Committee and the Fed have downplayed this possibility.

The speech argues that the CCyB should be raised now so that it can be lowered in a recession.  Lowering the CCyB in a recession can help prevent banks experiencing losses from shrinking their balance sheet by lending less to comply with capital requirements.

We agree that the capital requirements should be decreased in recessions for those same reasons.  However, the Fed’s stress tests have effectively increased capital requirements this year, so the CCyB does not need to be raised at this time, it just needs to be allowed to go below zero during a recession.

In an interview with the Wall Street Journal on June 28, Rosengren acknowledges that the Fed’s stress tests are already pushing banks to build up capital in good times.  In particular, this year’s stress scenarios were more severe relative to scenarios in previous years leading to larger declines in banks’ regulatory capital ratios under stress.  Indeed, a recent TCH blog post estimates that the 2018 stress tests increased large banks’ capital requirements by 1 percentage point relative to the 2017’s stress tests.  However, Rosengren points out correctly that the stress tests will not be very effective in lowering bank capital requirements in a recession.  While the stress scenario would entail less of an increase in the unemployment rate than currently, the unemployment rate would be starting from a higher level.

The reasoning presented in the speech to increase the CCyB now is very close to those on the FOMC (the Federal Open Market Committee, the Fed’s monetary policy setting committee) in 2008 who argued that the Fed should refrain from lowering the fed funds rate target to zero even as the economy was weakening so that they had the ability to lower the target to zero later when things were even worse.  This argument was known as “keep your powder dry.”  Ironically, President Rosengren (along with Ben Bernanke, Timothy Geithner, Donald Kohn, and Janet Yellen) strongly rejected the “keep your powder dry” argument.  If you want to avoid a bad outcome, policy needs to be easier, not tighter – you should move to zero sooner, not later.

Importantly, raising the CCyB now would require a change in the CCyB regulation.  The Board’s regulation implementing the CCyB states that it will raise the CCyB when financial system vulnerabilities are “meaningfully above normal” based in part on Fed staff’s quarterly assessment of financial stability.  But according to the most recent Monetary Policy Report to Congress, the Fed currently sees vulnerabilities as “moderate,” which we take to be below “meaningfully above normal.”  The report goes on to state that, while asset valuation pressures are “elevated,” those high asset prices are offset by “…capital and liquidity ratios of banks that have continued to improve from already strong positions.”

If the Fed concluded that it wanted to use the CCyB to encourage lending in the next recession, and it was ready to change its regulations to do so, there is a more sensible way than raising the requirement now:  The Fed could change the CCyB so that it could be made negative.  That way, rather than making a recession more likely by raising capital requirements now just so they could be lowered later, the Fed could simply lower requirements later.  To put the proposal in terms President Rosengren should find familiar, rather than keeping their powder dry, the Fed could be preparing to push through the zero lower bound.

Allowing the CCyB to be reduced below zero would also improve the Fed’s proposed “Stress Capital Buffer” (SCB) capital framework (for a description of the SCB proposal go here).  Under the proposal, bank’s continuous capital requirements (including the CCyB) and their annual stress test results would be combined.  As noted, the stress tests are not designed to become easier in a recession; moreover, in the SCB framework the contribution of the stress tests results can’t go below a 2.5 percent floor.  But setting the CCyB below zero in a recession would overcome this shortcoming by, in effect, lowering the stress test hurdle rate.  Also, the Fed used a lower hurdle rate for the Tier 1 common ratio in the 2009 stress tests (the only test conducted in a recession) compared to those conducted since.  Because it is no longer feasible to change the hurdle rate under the Fed’s SCB proposal, a similar outcome can be reached by lowering the CCyB below zero.

President Rosengren’s objectives are explicitly macroeconomic, not prudential or even macroprudential.  He laudably wants to make the next recession milder than it would be otherwise.  In the debate on whether monetary policy should be used to accomplish financial stability objectives, there is fairly widespread agreement that macroprudential tools should be preferred when possible, with monetary policy only used as a backstop.  (See, for example, Jeremy Stein’s speech “Overheating in Credit Markets: Origins, Measurement, and Policy Responses” February 7, 2013).  While less discussed, a corollary is that, when considering using prudential tools to achieve macroeconomic outcomes, monetary policy should be preferred, with changes in bank regulation and supervision used only as a last resort.

So why involve the CCyB at all?  By President Rosengren’s logic, the Fed should be raising the fed funds rate faster so they can lower it by more later.  That’s “keep your powder dry” on steroids, of course, and clearly bad policy.  Unless, perhaps, Rosengren thinks monetary policy should be tighter than it is but can’t get the FOMC to go along.  In that case, it also seems suboptimal and even dysfunctional to respond by tightening capital requirements on eighteen banks instead.  Squeezing just a subset of the financial system will not only unfairly restrict credit to bank-dependent sectors, it will also drive intermediation into the shadow banking system.  If capital requirements are to be raised and then lowered to achieve macroeconomic, rather than financial stability, objectives, then they should be raised and then lowered on all banks, large and small, and the Fed should limit and then boost leverage in the shadow banking sector by exercising its authority to increase and then decrease margin requirements.

In sum, if the Fed wants to be able to ease capital requirements in a recession, it simply needs to change its regulations so that the CCyB could be set negative.  A negative setting would fit well into the proposed SCB framework by countering the procyclicality of the stress tests.  And if the Fed wants to slow the expansion, it should use monetary policy tools to do so – raise the target federal funds rate, or shrink their holdings of longer-term securities more quickly.

Addendum:  Procyclicality in financial regulations is not limited to capital requirements. We show in a new little studied change in the treatment of loans losses from an “incurred loss” methodology to an “expected loss” methodology (CECL) is likely to contribute to a material contraction in lending during the next recession.  While the CECL methodology was designed to be countercyclical and to require banks to build loan loss reserves in good times, we show in a new working paper [link] that the new standard will instead be procyclical. Because forecasters are generally unable to successfully predict turning points in the business cycle, the new regime for accounting for losses will have the effect of sharply lowering banks’ capital ratios during the earlier part of a recession, exactly the opposite of what was intended.

Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.