The Federal Reserve Board’s (FRB) Governor Daniel Tarullo spoke on September 26, 2016 at the Yale School of Management. The Governor’s remarks covered a broad range of issues surrounding stress testing, including a new approach to conceptualize stress testing using a Stress Capital Buffer (SCB).1 This SCB approach would alter the overall structure of the Comprehensive Capital Analysis and Review (CCAR), resulting in additional capital requirements for eight of the biggest Wall Street lenders, while simplifying the requirements for regional banks that have less impact on the health of the global financial system.2 “In pulling this package of modifications together, we have consciously shaped them in accordance with the principle that financial regulation should be progressively more stringent for firms of greater importance, and thus potential risk, to the financial system,”3 Governor Tarullo said.

What this Means

Governor Tarullo noted that while CCAR programs have made important contributions to protecting the soundness and safety of the largest financial institutions, and encouraging the stability of the entire financial system, in order for the stress testing regime to continue to do so, it should be dynamic. The testing scenarios may need to be changed to reflect new economic and financial risks, as well as evolving bank portfolio characteristics and economic conditions. After much discussion and analysis, the Fed have developed ideas for changing the CCAR stress testing. These would address the issues of regulatory capital requirements, prudential capital regulation, and the nature of the qualitative assessment as it applies to smaller, less complex firms within the CCAR exercise. Some of the changes would have to be addressed through rulemakings, while others could be implemented through non-regulatory changes.4

To better align CCAR with the regulatory capital rules the Fed will adopt an SCB approach. This approach will be risk-sensitive, will vary across financial firms and be based on the results of the annual CCAR stress tests. For global systemically important banks (G-SIBs) where a capital surcharge exists as an additional buffer requirement in the regulatory capital rules, the SCB approach will effectively add the G-SIB capital surcharge to the estimates of the amount of capital needed under stress. This should result in a significant increase in capital requirements applicable to G-SIBs.5 Some industry representatives have argued that this is duplicative and not warranted.

However, the basis of the G-SIB surcharge is to capture the impact of a G-SIB failure on the entire financial system, which is not captured in the SCB requirements. These elements of the stress tests apply only to G-SIBs as they are the only firms in CCAR for which these exposures are important. Non G-SIBs do not have material trading activities and thus would suffer only minor losses as a result of severely stressed market conditions.6

As a result the Fed will propose easing CCAR stress test requirements for banks with less than $250 billion in assets, eliminating the qualitative portion of CCAR, along with some record keeping and reporting requirements.7 This proposed change will affect 15 to 20 US banks, with $50 billion and $250 billion in assets. They will still have to demonstrate to the Fed that they are in a position to survive a stressed scenario with enough capital to continue lending.8 But starting in 2017 they will not have to pass the qualitative portion of the CCAR stress tests, in which the Fed does a comprehensive review into risk management systems.9 The change is designed to make the test less onerous for medium sized and community banks, to “reflect the lower systemic risk profile and less complex operations” of banks with assets under $250 billion,10 said Governor Tarullo.

These changes in CCAR are intended to tailor the stress tests in order that they remain a dynamic regulatory instrument, whose procedures will be refined on a regular basis, and whose substance will be regularly adapted to changing industry practices and economic conditions.11

Key Observations and Take-aways

The changes outlined have two major impacts, for G-SIBs and the smaller regional and community banks. In short, the G-SIBs will see their capital requirements rise. All other CCAR will see some reduction in their capital requirements. And firms that have less than $250 billion in assets and do not have extensive international or non-traditional banking activities will also transition to a more tailored set of capital planning expectations outside the CCAR process. For further details on the CCAR requirements, please see the most recent CCAR Regulatory Alert titled “Federal Reserve Board proposes rule to modify its capital plan and stress testing rules for 2017 cycle.”12

 

References

  1. “Understanding the Implications of Fed Governor Tarullo’s Suggested Changes to Stress Testing,” The Clearing House, September 27, 2016. Access at: https://www.theclearinghouse.org/eighteen53-blog/2016/september/27-tarullo-stress-testing.
  2. “Understanding the Implications of Fed Governor Tarullo’s Suggested Changes to Stress Testing,” The Clearing House, September 27, 2016. Access at: https://www.theclearinghouse.org/eighteen53-blog/2016/september/27-tarullo-stress-testing. “Fed to Ease Stress Tests for Regional Banks,” The Wall Street Journal, September 26, 2016. Access at: http://www.wsj.com/articles/fed-to-ease-stress-tests-for-regional-banks-1474904701.
  3. “Fed to Ease Stress Tests for Regional Banks,” The Wall Street Journal, September 26, 2016. Access at: http://www.wsj.com/articles/fed-to-ease-stress-tests-for-regional-banks-1474904701.
  4. “Next Steps in the Evolution of Stress Testing,” Board of Governors of the Federal Reserve System, Governor Daniel K. Tarullo, Speech, September 26, 2016. Access at: http://www.federalreserve.gov/newsevents/speech/tarullo20160926a.htm.
  5. Ibid
  6. Ibid
  7. “Next Steps in the Evolution of Stress Testing,” Board of Governors of the Federal Reserve System, Governor Daniel K. Tarullo, Speech, September 26, 2016. Access at: http://www.federalreserve.gov/newsevents/speech/tarullo20160926a.htm
  8. Ibid
  9. Ibid
  10. “Fed’s Tarullo Says Stress Tests to Get Tougher for Big Banks,” Bloomberg, June 2, 2016. Access at: http://www.bloomberg.com/news/articles/2016-06-02/tarullo-says-eight-biggest-banks-to-face-higher-capital-rules
  11. “Next Steps in the Evolution of Stress Testing,” Board of Governors of the Federal Reserve System, Governor Daniel K. Tarullo, Speech, September 26, 2016. Access at: http://www.federalreserve.gov/newsevents/speech/tarullo20160926a.htm
  12. Ibid

Newsletter Author: Samantha Regan, Mairi Bryan

Newsletter Contact Person: Nghi Pham

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