Update 188 — Banks Pass Stress Tests; Will the Tests Themselves Be Tested?
Last Thursday, the Federal Reserve released its qualitative analysis upon reviewing the Comprehensive Capital Analysis and Review (CCAR) stress test results from the week be fore. The analysis is the basis for the Fed’s verdict regarding the capital status of the nation’s 34 banks with consolidated assets in excess of $50 billion.
33 of the 34 firms are free to pursue their corporate finance plans for the next year without constraints on stock repurchases or dividend policy under DFA section 165 (d). The Fed granted a conditional OK to Capital One; the firm may fix insufficiencies in its capital planning practices and submit a plan in six months.
CCAR and DFAST, the Dodd-Frank mandated capital regime stress tests, have been conducted annually since the recession. Policymakers have considered making adjustments to both programs. What are implications for the DFA reform process on stress testing, given that almost every bank passed this year?
2017 CCAR Results
The capital plans of all 34 banks subject to CCAR were given the OK by the Federal Reserve for the first time in CCAR’s eight-year history. Capital One earned a conditional non-objection and must submit again in six months. American Express made minor adjustments to its plan to pass the test.
History of CCAR Results
CCAR has been a critical program to motivate balance sheet accountability among large banks and confidence in them post crisis. Without CCAR, the largest banks would have not have built and maintained the safe capital regimes they now have. Second, without regular testing, banks may assume others will pick up the costs or they will be bailed out again.
At the nadir of the recession in the spring of 2009, regulators subjected the largest banks to the first US regulatory-administered round of stress tests (until 2007, stress testing was typically administered internally by banks for self-assessment purposes). In announcing the results of the Supervisory Capital Assessment Program that March, the Fed forced hundreds of institutions to raise or receive injections of more capital. The beginning of the recovery was marked by this announcement in March 2009, as firms saw other institutions’ actual capital conditions for the first time. Confidence rose from that point in banks’ liquidity and ability to make payments. Before then, institutions were not making overnight payments to close books on transactions.
Every year since, US firms have substantially increased their capital buffers and quality. Specifically, the largest banks have increased capital levels to $1.2 trillion from $500 billion in 2009. Per the Fed: “The common equity capital ratio–which compares high-quality capital to risk-weighted assets–of the 34 bank holding companies in the 2017 CCAR has more than doubled from 5.5 percent in the first quarter of 2009 to 12.5 percent in the first quarter of 2017.”
This is the first year since the recession that the Fed has cleared all big banks capital return plans. CCAR stress testing has provided a good indicator for the financial system’s health. The GOP may argue that these results undermine the necessity of the test.
Consequences of Test Results
Following last week’s results, the nation’s four largest banks announced they will devote $44 billion to stock buybacks — $15 billion more than last year, boosting the price of their stock. Other firms also announced they will proceed with buybacks and dividend payment plans held in abeyance until this announcement.
Progressives might argue that increased buybacks constitute irresponsible shareholder-enrichment and the abandonment of lending and investment in the middle class. We often hear compliance costs of regulation curtail lending that would benefit communities, but wouldn’t a redirection of stock buybacks toward lending serve a greater purpose? A neutral assessment might pay respect to firms for adjusting their planning in accordance with Fed’s evaluation.
Qualitative vs Quantitative Results
CCAR consists of two reviews, qualitative and quantitative. The results of the quantitative review, which evaluates capital adequacy were released June 22. This review evaluates firms’ capital finance plans.
In late January, the Fed announced the exemption of some large and complex firms from the qualitative review, and would focus them solely on the largest SIFIs. The Fed specifically exempted BHCs with assets totaling between $50 billion and $250 billion (regional banks), total nonbank assets of less than $75 billion, banks with less than $10 billion in foreign exposure and banks that are not identified as global systemically important banks (GSIBs). SIFIs with over $250 in assets are still subject to the qualitative evaluation.
Treasury made two proposals regarding the qualitative component of CCAR:
- the qualitative portion should no longer serve as the sole basis for the Federal Reserve’s objection to a capital plan.
- the qualitative assessment should be adjusted to conform to the horizontal capital review standard the Federal Reserve has already implemented for non-complex banking groups with assets less than $250 billion.
Republicans may point to the health of the banks to justify proposals to end or limit CCAR requirements for some of the smaller of the 34 banks, including at least a change in the $50 billion threshold for CCAR testing. The GOP’s operative logic — because CCAR requirements are working so well, we no longer need them. Per Ranking Member of Senate Banking Sherrod: “If no one fouls out in a game, you don’t fire the referees.” This is flawed reasoning. If anything, the results prove how well CCAR has worked for so long as a key diagnostic for the state of the financial system’s health.
Republicans have also sought changes to CCAR transparency that would, first, open public comment for rule-writing to financial institution lobbyists and, second, make the Fed’s CCAR methodology public so SIFI’s can be cued to what will be factored into the CCAR process.
DFA supporters viewed the test results as a validation of the regulatory regime. If Republicans are pushing heavily for some relief, Democrats could offer adjusting CCAR in exchange for preserving an automated SIFI Threshold. An automated SIFI threshold would mean that any bank that crosses the threshold would automatically be designated and subject to heightened systemic risk safeguards.
One reform under discussion would be to reduce the frequency of DFAST stress tests for mid sized banks, those $10-50 billion in assets. Sens. Heitkamp and Tester have introduced a bill proposing another change. S. 1139, the Main Street Regulatory Fairness Act, would make the DFAST tests less frequent and increasing the asset threshold for such testing from $10 billion to $50 billion. The proposal found its way into Treasury’s report.
Critics of this measure say it gives discretion on the matter to regulators, who will likely be Goldman and Trump loyalists within a few years. But by offering some adjustment to CCAR that already has much support and does not increase systemic risks, Democrats can secure an off-setting protection.
Stress Tests and Talks
This year’s almost universally positive CCAR results means that negotiating parties may be tempted to use CCAR as a bargaining chip in a broad discussion of financial reform tweaks. Negotiators will explore what changes to CCAR and DFAST improve or diminish bank performance. Banks have certainly gotten better at understanding and passing these evaluations every year. The value of these tests could be seen as diminishing annually. As firms are more practiced and doing better, results are more uniform, and compliance costs are sunk or cut.
Democrats may add offerings adjusting the program in the area of frequency, the threshold level at which it applies, and the transparency of the process. If enough Democrats conclude it is not costly to, for example, exempt firms with around $10 billion in assets from DFAST, the party could posture the change as a substantial concession. Compliance costs are more significant for those firms – which are not systemically important – relative to the gigantic firms.
It is easy to imagine discussions regarding the tests’ qualitative review for banks of particular sizes, enabling Democrats to yield here in exchange for the preservation of a progressive sacred cow DFA provision to be named later.