In testimony before the House Financial Services Committee yesterday, Federal Reserve Chair Janet Yellen criticized TCH’s recent study, “The Capital Allocation Inherent in the Federal Reserve’s Capital Stress Tests,” which evaluates how the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) exercise impacts different types of lending and other activities.
Her testimony indicated that the Federal Reserve believes the study has several flaws, though only had time to identify one in Q&A when asked to elaborate. Namely, Chair Yellen noted that the study estimated the effective CCAR risk weights under the stress tests using the average quality of banks’ portfolios and not the quality of marginal or new loans. This criticism appears to imply that TCH’s estimates of effective risk-weights are higher than the risk-weights of new loans being originated at banks, and that it is the latter that affects capital allocation. This criticism does not at all undermine the core conclusion of our study – that CCAR has a disproportionate and negative impact on small business and other types of lending — for several reasons:
- First, the implicit risk weights under CCAR at an average portfolio level are, if anything, more relevant in assessing CCAR’s impact on different types of lending. There are several reasons for this.
- Banks’ lending decisions will be influenced by the required capital expected over the life of the loan, not just at inception. Consequently, at least in the steady state, the average portfolio performance under CCAR, not simply the marginal performance of each new loan, is an important determinant of a bank’s portfolio allocation decision.
- Regardless of whether the quality of new loans is significantly and permanently better than the quality of existing loans on banks’ balance sheets, it is how they perform under the severely adverse scenario of the stress tests, and not their risk at origination under ordinary conditions, that attracts elevated capital charges. Because CCAR is a forward-looking exercise, estimates of likely capital charges any new loan will incur must be equally forward-looking, and not focused solely on capital consequences at the time a loan is originated. A key point of our note and our earlier work is that the extreme severity of the stress scenarios in CCAR induces banks to stop lending to borrowers with less than pristine credit scores because the risk of such borrowers rises significantly under the stress scenarios.
- Second, it is important to recall that our study focused on implicit risk weights under CCAR relative to those implicit in (i) DFAST (i.e. the process in which banks use their own, Fed-approved, models to project losses) and (ii) Standardized risk-based capital rules. Even if one accepts the criticism that evaluating average portfolio effects may overstate the risk weight of new loans, any overstatement from using higher-risk loans in portfolio would be exactly the same for DFAST as for the Fed’s own CCAR models. Thus, the relative difference in capital charges between the Fed’s and banks’ own models – the point of our study – would be entirely unaffected. Thus, at best, this criticism is irrelevant to half of the findings of the report — and the far more important half. This is because DFAST results are a much better indicator than Standardized results if one is seeking to determine the types of loans that banks would make if the Fed’s CCAR models were not the binding constraint.
- Third, it is certainly true that our study estimated CCAR’s implicit risk weights using the decline in regulatory capital ratios under stress which reflects the performance of the average quality of banks’ loan portfolios, and not the quality of new loans being originated. This is a function of data limitations – because the Federal Reserve’s methodology and models are nonpublic, and results are published at a portfolio level, only the Federal Reserve is capable of performing a similar evaluation of specific loan cohorts. We note they have not publicly undertaken such analysis to date.
We also note that the results of our study are consistent with results of two recent papers authored by Federal Reserve staff. For example, a recent paper presented at the American Economic Association meetings by Fed staff in early January “found a negative and significant effect of changes in capital regulatory requirements measured as declines in capital ratios as estimated in stress-tests on loan growth. The average effect for the sample of CCAR BHCs ranges between 3 and 8 p.p…” (page 6). Second, a recent working paper published by the Federal Reserve Board “find[s] that the first Comprehensive Capital Analysis and Review (CCAR) stress test in 2011 had a negative effect on the share of jumbo mortgage originations and approval rates at stress-tested banks – banks with worse capital positions were impacted more negatively.”
We hope our study continues to attract greater attention to the opacity of the U.S. stress tests and their substantial impacts on bank lending. We would be eager to discuss additional comments the Federal Reserve has about our study.
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.