Yesterday, the Federal Reserve released the results of the 2018 Comprehensive Capital Analysis and Review (CCAR). As described in previous TCH’s posts, the 2018 results were crucially driven by the increased severity in this year’s hypothetical set of stressful economic and market conditions developed by the Federal Reserve. As a result, banks’ capital requirements have increased by approximately one percentage point based on our analysis of this year’s stress results. In this blog post, we describe how that happened and discuss some of the current challenges banks face regarding the integration of the regulatory capital rules with the CCAR and stress testing rules through the stress buffer requirements proposed by the Federal Reserve. In summary:
- Excess capital (i.e., the maximum amount of capital a bank can return to its shareholders without violating any capital requirement) declined by $91 billion, driven by the extreme severity of the Fed’s stress scenario in this year’s exercise.1 In previous research, we demonstrated that excess bank capital is an important determinant of economic growth;
- The resulting increase in capital requirements is likely to increase the cost of bank loans, especially to cyclically sensitive sectors, including loans to corporations that are not considered “investment grade”, small businesses, and households with less-than-pristine credit histories;
- This year’s results illustrate that capital requirements in the United States are highly volatile from year to year and that the volatility will be magnified by the integration of the regulatory capital rules with the CCAR and stress testing rules under the stress buffer requirements proposal; and
- Lastly, the potential removal of the qualitative assessment of CCAR (as speculated by a recent Wall Street Journal article) would not reduce banks’ incentives to invest in passing the stress tests. If anything, the importance of stress testing is likely to increase as a result of the proposed stress buffer requirements and the proposed rating system for large financial institutions.
Implausibility of the Fed’s Stress Scenario
This year’s stress tests featured a downturn in the U.S. economy that is significantly more severe than previous years’ supervisory stress scenarios and the 2007-2009 financial crisis. The Fed designs its stress scenarios using what it calls “a recession approach,” in which the severely adverse scenario is intended to “reflect conditions that characterize post-war U.S. recessions, generating either a typical or specific recreation of a post-war U.S. recession.” This year’s scenario is clearly inconsistent with that standard.
As an illustration of the extraordinary implausibility of this year’s stress scenario, the two charts below compare density forecasts of the unemployment rate during the 2007-2009 financial crisis (left panel) with its path under the Fed’s severely adverse scenario (right panel). During the first 9 quarters of the 2007-2009 financial crisis, the realized unemployment rate was always less than the 99th percentile (the yellow portion of the cone).2 In practical terms, the chart shows that the past crisis was very severe as the observed path of the realized unemployment rate lies in the extreme tail of our density forecast for some quarters, especially during 2009. However, as can be seen in the chart to right, under the severely adverse scenario in CCAR 2018, the path of the unemployment rate is almost always above the 99th percentile of our forecasts. Indeed, the unemployment rate path under the severely adverse scenario approximately corresponds to the worst path we were able to generate across thousands of simulations of our model. Moreover, the rise in the unemployment rate is assumed to take place much more rapidly than was true in the financial crisis, causing losses under the Fed’s scenario to ramp-up very quickly. We can find no historical antecedent for the suddenness of the stress in the unemployment rate.
Increase in Capital Requirements in CCAR 2018
The overall increase in the severity of the hypothetical set of stressful economic and market conditions developed by the Fed (including the global market shock and the counterparty default scenario in addition to the remaining series included in the macroeconomic stress scenario), has resulted in a significant tightening of large banks’ capital requirements. The chart below depicts the change in excess capital using CCAR 2017 and CCAR 2018 results for three bank groups: (1) All CCAR banks that have participated in both the 2017 and 2018 CCAR exercises (and had their results reported by the Fed); (2) GSIBs only; and (3) non-GSIBs. For all CCAR banks, the amount of excess capital declined from $173 billion based on CCAR 2017 results to $82 billion using the results of 2018 CCAR exercise. The $91 billion drop in excess capital corresponds to approximately 0.93 percent of banks’ risk-weighted assets. As a result, banks’ capital requirements have increased by approximately 1 percentage point based on the analysis of this year’s stress results. Although, banks’ capital levels went down at the end of last year because of the U.S. tax reform, leading to a decline in excess capital under CCAR, we estimate using DFAST 2018 results that banks’ proposed stress capital buffers would rise 0.90 percentage points in aggregate relative to DFAST 2017 results. Although, changes to the U.S. tax code have undoubtedly increased the size of the proposed SCB as it accelerates the decline in regulatory capital ratios under stress due to the lower corporate tax rate, the SCB estimate is invariant to the level of capital at the start of the stress tests.
In addition, as shown by the middle and right-most bars, the tightening in capital requirements is much higher for the eight U.S. GSIBs relative to other banks. In particular, excess capital drops $76 billion for GSIBs and $16 billion for non-GSIBs with the release of this year’s CCAR results.
Some Challenges Going Forward
As noted above, the stress buffer requirements proposal would integrate the regulatory capital requirements with the CCAR and stress testing rules. As a result, banks subject to these rules would need to meet heightened capital requirements year-round in order to avoid being subject to restrictions on capital distributions. Under the proposal, a bank’s stress capital buffer (SCB) would be calculated as the greater of (i) 2.5% of risk-weighted assets and (ii) its peak-to-trough stress losses in the DFAST exercise. This means that bank’s would be required to capitalize themselves year-round against the losses they would incur under the Federal Reserve’s severely adverse scenario. The proposal also attempts to eliminate the quantitative pass/fail nature of CCAR.
Integrating the stress capital buffer into year-round capital requirements would exacerbate the capital management challenges created by the year-to-year variability of the Federal Reserve’s supervisory scenarios and the lack of transparency of its supervisory models. As the supervisory scenarios change from year to year, a bank’s capital requirements would also likely fluctuate annually as they are based on the stress losses calculated under DFAST. In addition to the supervisory scenarios, the supervisory models themselves are a significant cause of uncertainty in the stress testing exercise (as suggested by the record number of banks that had the “take a mulligan” in CCAR 2018). Banks have insufficient information about these supervisory models, despite the significant role they play currently in determining bank capital requirements and the greater role they will play following finalization of the stress buffer requirements. In order to avoid payout restrictions, these annual fluctuations would likely result in banks’ holding additional capital buffers, and therefore providing less credit to businesses and households, to manage this regulatory uncertainty.
For the largest U.S. banks (GSIBs), if the SCB is implemented as proposed, in addition to meeting their SCB requirement, they would be required to hold enough capital to meet their GSIB surcharge (an additional capital buffer that each U.S. GSIB is required to hold, over and above its risk-based capital requirements and other capital buffers, as we have described in more detail here). Currently, GSIBs are required to hold enough capital to cover their minimum capital requirements plus their GSIB surcharge as part of their standing regulatory capital requirements, but these are not calculated on a post-stress test basis. Despite other improvements to the stress testing regime contained in the stress buffer requirements proposal that greater align the CCAR assumptions with historical experience and empirical data, the capital requirements of the eight U.S. GSIBs would rise further under the SCB proposal as a result of adding the GSIB surcharge to the stress capital buffer.
The table above shows that excess capital would further decrease by an additional $7 billion for the eight U.S. GSIBs as a result of effectively adding the GSIB surcharge to post-stress requirements, and would increase $48 billion for the non-GSIBs due to the elimination of the assumption that banks’ balance sheets and risk-weighted assets grow under stressed conditions and the removal of the common stock dividend and repurchase assumptions. As noted in previous blog posts and comment letters, given the inclusion of the GSIB surcharge to the post-stress minimums, the Federal Reserve should revisit and recalibrate the GSIB surcharge to reflect the impact of post-crisis regulations on improving the degree of resiliency of U.S. GSIBs.
Lastly, The Wall Street Journal published an article this week stating that the proposed changes to the CCAR exercise would result in banks having “less urgency to invest in passing the stress tests”. The article’s conclusion is based on the fact that, under the proposal, banks would no longer be subject to the highly visible quantitative “pass-fail” aspect of the stress test and the article further assumes that the Fed will ultimately remove the qualitative “pass-fail” aspect of the stress test as well. However, the conclusion overlooks elements of the proposal that would increase, not decrease, the importance for banks of passing the stress test. As noted above, following implementation of the SCB, banks would be required to capitalize themselves against stress losses year-round, the volatility of bank capital requirements is likely to be significantly increased, and for a number of the largest banks capital requirements are expected to increase. While in many prior years (including last year) the stress tests were effectively moot because non-stressed requirements were more binding, under the proposals the stress tests results would always be binding.
Additionally, while the article presumes the elimination of the qualitative pass/fail portion of CCAR (which although not contained in the stress buffer requirements proposal, we strongly support), it appears to assume that banks wouldn’t be subject to supervisory oversight of their capital planning processes or suffer any consequences from deficiencies in their capital planning process.
However, another current proposal by the Fed is a revision to their rating system for large financial institutions (LFI). A key component of the proposed LFI ratings system is determined by the Fed’s assessment of a firm’s capital planning processes. The elimination of the qualitative assessment would not alter in any way the Fed’s actual supervisory expectations and requirements regarding capital planning. And there isn’t anything about the examination process or the Fed’s supervisory authority that would limit its ability to qualitatively assess an LFI’s capital planning processes through the ordinary examination and supervisory process. The consequences of being found deficient would still be quite severe – it could be a barrier for a firm seeking approval to engage in new or expansionary activities or result in a bank being found to be in “troubled condition” which carries a significant burden.
For the reasons noted above, the stress buffer requirements proposal is likely to increase the importance of stress testing and even if the Fed does eliminate the qualitative pass/fail portion of CCAR, banks won’t feel any “less urgency” to ensure they pass the stress tests.
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, and are not intended to be, and should not be construed as, legal advice of any kind.