Stress Testing: Is Now the Time to Move the Goal Post?
Usually regulatory reform and rationalization is welcome by the financial services sector. However, when such changes are made in the middle of an ongoing compliance cycle, and that cycle happens to coincide with a pandemic, the industry may ask why the regulators are moving the goal post in the middle of the Ice Bowl. In that theme, the Board of Governors of the US Federal Reserve System (“Board”) recently took two actions to change parts of its stress testing requirements that will impact the ongoing 2020 stress testing cycle.
First, on March 4, 2020, the Board finalized its stress capital buffer (“SCB”) rulemaking to integrate the regulatory capital rules with the Comprehensive Capital Analysis and Review (“CCAR”) exercise.1 The SCB rule was finalized after the start of the 2020 CCAR cycle but will be in effect for part of that cycle.
Second, on April 10, 2020, Board Governor Randal Quarles announced that the Board would change the 2020 CCAR exercise to include consideration of how banking organizations are responding to COVID-19.2 This change was announced in the middle of the exercise, after organizations had submitted the results of the Dodd-Frank Act stress tests and their capital plans to the Board for non-objection.
Below we discuss the changes made by the SCB rule and the inclusion of COVID-19 in the 2020 CCAR exercise.
Since enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”), there was a concern that large banking organizations were subject to numerous and duplicative capital requirements due to changes in regulatory standards and requirements to conduct stress testing.3 In some cases, organizations were required to measure compliance against dozens of requirements.4 In other circumstances, a requirement that was intended to be a backstop operated as a binding constraint against new initiatives.
In April 2018, the Board proposed simplifying the capital requirement for larger banking organizations through the introduction of a stress capital buffer that would integrate and replace capital requirements in the Basel III and existing stress testing/capital planning regimes.5 On March 4, 2020, the Board finalized the SCB modifications and announced that they would apply to part of the 2020 CCAR cycle.
The SCB rule largely tracks the April 2018 proposal, with certain modifications that respond to industry feedback and that reflect amendments required by the Board’s 2019 rulemaking that tailored capital requirements for larger banking organizations.6 The SCB rule applies only to banking organizations that currently are subject to the capital plan rule (i.e., US bank holding companies and US intermediate holding companies with $100 billion or more in total assets).
Under the SCB rule, a banking organization’s stress capital buffer is calculated as the sum of (i) the difference between the organization’s starting and minimum projected common equity tier 1 capital ratios as calculated under the severely adverse scenario specified in the supervisory stress test and (ii) four quarters of planned common stock dividends as a percentage of risk-weighted assets. The stress capital buffer requirement, which applies on top of an organization’s minimum risk-based capital requirement, may be no less than 2.5 percent of risk-weighted assets and replaces the 2.5 percent of risk-weighted assets portion of the capital conservation buffer requirement under the Basel III standardized approach.7 An organization whose capital ratios are at or below its minimum, taking into account its stress capital buffer requirements, the applicable global systemically important bank holding company (“G-SIB”) surcharges, and its countercyclical capital buffer is subject to automatic restrictions on capital distributions.
The SCB rule modified the CCAR exercise by reducing the number of quarters an organization will be assumed to take capital actions while under stress from nine to four. In addition, the SCB rule modified the CCAR exercise to assume that an organization will maintain a constant level of assets over the planning horizon rather than assuming a growing balance sheet over the planning horizon. Further, the SCB rule (i) removed the 30 percent dividend payout ratio currently applied as a criterion for heightened supervisory scrutiny of an organization’s capital plan and (ii) generally removed the quantitative objection process and prior approval requirement for capital distributions that comply with the capital rules.
Additionally, in the final rule, the Board made the following additional changes from the April 2018 proposal. First, under the final rule, organizations will not be required to include the effect of an unconsummated material business plan change in their stress capital buffer calculation.
Second, the Board decided to not implement a stress leverage buffer requirement. This decision does not affect the existing non-stress leverage ratio requirements that apply through the regulatory capital rules.
Third, the proposal did not fully account for how the integration of stress test results could increase the likelihood that an organization would trigger limitations on capital distributions. The SCB rule attempted to remedy this cliff-effect by adopting an average of earnings as the base to calculate capital distribution limitations with respect to an organization’s stress capital buffer requirement that is beyond 2.5 percent of risk-weighted assets.
Fourth, the proposal would have retained the requirement for an organization to seek prior approval from the Board to make capital distributions in excess of the planned distributions included in the organization’s capital plan. Based on industry feedback, the Board omitted this requirement from the SCB rule (although it retained a 15-day notice requirement for such actions).
On April 10, 2020, Governor Quarles announced that the Board would adjust the 2020 CCAR exercise to include consideration of how banking organizations are responding to COVID-19. This mid-cycle adjustment raises questions about how the Board will evaluate the organizations’ stress testing and capital plan submissions in light of the economic consequences of the COVID-19 pandemic.
Banking organizations seeking to comply with the timeline set forth in the Board’s capital plan rule submitted their stress test results and proposed capital plans to the Board on April 6, 2020.8 These submissions responded to hypothetical stress testing scenarios and instructions issued by the Board in early February but did not incorporate the real-world effects of COVID-19. Governor Quarles’ comments suggest that the Board will now use organizations’ stress test submissions to evaluate how their portfolios are responding to current events.
It is not clear at this point whether the Board will adjust the standards it uses to evaluate the submissions or whether banking organizations will be required to revise or make resubmissions. The Board has moved away from using qualitative assessments as a driver of the CCAR exercise, which may indicate that the Board will adjust its quantitative analysis of financial projections.9 What is clear, however, is that the hypothetical stressed scenarios on which the financial projections are based differ substantially from the economic stresses that were triggered by the COVID-19 pandemic.
The Board’s deadline to announce the results of the test, and to object to any proposed capital plans, is June 30, 2020.10
The SCB rule reduces the number of capital requirements certain banking organizations must meet from 13 to eight and generally should reduce the amount of capital that Category II, III, and IV banking organizations (i.e., non-G-SIB large banking organizations) must hold. While the SCB rule is effective May 18, 2020 (and therefore, will be effective for the supervisory stress testing component of the 2020 CCAR cycle), the modified capital requirements will not apply until October 1, 2020.11 This phased approach may mitigate some of the financial uncertainty associated with introducing new rules while the CCAR exercise is underway.12
The inclusion of COVID-19 into the Board’s evaluation of stress testing results and proposed capital plans will apply retroactively to the materials submitted last week by banking organizations. It remains unclear what standards the Board will use to evaluate the COVID-19 stress scenario.
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1 Press Release, Federal Reserve Board approves rule to simplify its capital rules for large banks, preserving the strong capital requirements already in place (Mar. 4, 2020), https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200304a.htm; see also 85 Fed. Reg. 15,576 (Mar. 18, 2020).
3 E.g., 85 Fed. Reg. at 15,577 (“although the capital plan rule and the capital rule share similar goals, they were developed separately, and this has led to certain significant redundancies in the Board’s capital framework”).
6 84 Fed. Reg. 59,032 (Nov. 1, 2019); 84 Fed. Reg. 59,283 (Nov. 1, 2019). The SCB rule also indicates that the Board intends to propose at a future date modifications to further simplify and increase the transparency of the stress testing regime but remains concerned that such changes could increase the risk of organizations “window dressing” test results.
8 The Board extended the deadline for submitting one element of the stress testing results from April 6, 2020, to May 11, 2020. This extension did not affect the timely submission of most of the stress testing results, and the Board indicated that it would not affect its determinations. See 85 Fed. Reg. 17,723, 17,727 n.9 (Mar. 31, 2020).
9 Press Release, Federal Reserve Board announces it will limit the use of the ‘qualitative objection’ in its Comprehensive Capital Analysis and Review (CCAR) exercise, effective for the 2019 cycle (Mar. 6, 2019).