Behold the radical continuity of the Fed’s capital proposals

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WASHINGTON — In just two days over the past week, federal regulators issued a pair of proposals that would bring about the most substantial changes to capital requirements for the largest banks in years.

Yet to some, the most startling thing about the proposed reforms was how unremarkable they turned out to be.

The Federal Reserve Board on Tuesday unveiled a proposed rule to swap out a currently required capital buffer for a simpler measure more tailored to an individual institution's risk. The next day, the Fed along with Office of the Comptroller of the Currency proposed easing the "enhanced supplementary leverage ratio" for the biggest banks, despite the Federal Deposit Insurance Corp.'s opposition.

Both would be noteworthy changes and continue the deregulatory trend of the Trump era. But many observers were quick to point out that the proposed reforms were first envisioned by Obama appointees, with some analysts even expressing disappointment that the Fed did not go further.

“I certainly would not view this as any kind of an overhaul or rollback or anything like that,” said Laura Kuntz, partner at Lowenstein Sandler. “What it does is tweaks certain aspects of the existing rules and attempts to alleviate inconsistencies and to make things somewhat more firm-specific.”

The first proposal would replace the static "Capital Conservation Buffer" with a so-called Stress Conservation Buffer, which would be made up of the bank’s simulated capital losses in the prior year’s stress test plus four quarters of planned dividend payments. The special surcharge for global systemically important banks, or G-SIBs, would be applied in addition to the stress capital buffer.

While the change would likely be welcomed by banks, the idea for a stress capital buffer was first articulated by former Fed Gov. Daniel Tarullo, an Obama appointee seen as one of the toughest regulators after the crisis, in a speech in 2016.

Meanwhile, the proposed changes to the enhanced leverage ratio, known as the eSLR, revealed some divisions among regulators. Fed Gov. Lael Brainard voted against the proposal, which would effectively reduce capital requirements for many large banks, and the FDIC — which was instrumental in crafting the original eSLR rule in 2015 — made clear it did not agree with the latest proposal.

But former Fed Chair Janet Yellen, current Chairman Jerome Powell and Tarullo had all previously expressed an interest in reforming the eSLR, primarily in light of its effect on custody banks.

David Wright, managing director of banking and securities at Deloitte, noted that the Fed and OCC's decision to move ahead with the eSLR proposal despite not having a unified consensus among bank regulators is likely a reflection of the fact that the FDIC is still headed by two holdover Obama appointees — Chairman Martin Gruenberg and Vice Chairman Thomas Hoenig — and the agency's attitude could change with new leadership. (The nomination of Jelena McWilliams to run the FDIC is still pending.)

“There’s obviously going to be further changes on the FDIC board as Trump appointees are approved and put into place,” Wright said. “[Gruenberg] and the current FDIC board members feel strongly about it and have been consistent in trying to defend all kinds of leverage ratios, but the profile of the FDIC will be changing.”

The first proposal, on the stress capital buffer, would also change how the leverage ratio is calculated during the Comprehensive Capital Analysis and Review stress testing process.

Whereas CCAR previously required banks to maintain enough post-stress capital to clear the 4% leverage ratio, as well as a broader 3% supplemental leverage ratio and any enhanced ratio, the new proposal would replace the 4% leverage ratio requirements with a "stress leverage ratio," which represents the bank’s leveraged losses in the prior year’s stress test.

The effect of the change would be to replace the static 4% leverage ratio as a minimum capital standard with a more dynamic leverage ratio that is less likely to act as a binding constraint, particularly for custody banks like State Street and BNY Mellon.

The other proposal would replace the eSLR — which had been a simple 2% additional capital buffer for the largest globally active banks — with a ratio that represents 50% of the holding company’s G-SIB surcharge.

Wright said the stress capital buffer proposal hews very closely to the framework Tarullo laid out, and there may even be some in the banking industry disappointed that the Fed did not go further.

“Some might have suspected that the administration, the new Fed governors would have had stronger influence in going further in relaxing [the rules] than Dan Tarullo would have done, but in fact they didn’t,” Wright said. “So maybe that is a surprise.”

But there are some important elements in the proposals that the big banks will support.

Making the leverage ratio less of a binding constraint is something that the G-SIBs have long sought. The stress capital buffer proposal also eliminates the Fed’s quantitative objection — effectively meaning that banks can’t “fail” the stress test anymore. Instead, banks would be required to maintain their capital ratios on a standing basis, and CCAR would serve more as a means of setting those ratios on an annual basis.

Brian Klock, a managing director who covers midsize banks at Keefe, Bruyette & Woods, said the non-G-SIB banks that are still subject to stress testing are the biggest winners from the stress capital buffer proposal. Since last year, most banks with less than $250 billion in assets have been exempted from qualitative objections in CCAR, he said, and with the elimination of the quantitative objections, those banks can look forward to a smoother ride through the stress testing process.

“They’re not getting rid of the stress test process altogether,” Klock said. “But for all the $250 [billion in assets] and below, the noncomplex banks, they don’t have a qualitative failure risk, it was removed last year. To them … you don’t have to be on pins and needles wondering if the Fed is going to fail you.”

Mike Alix, financial services advisory risk leader at PricewaterhouseCoopers, said that outcome is consistent with the Fed’s avowed preference for relieving capital constraints for midsize regional banks and community banks and somewhat tighter scrutiny for the G-SIBs.

“There’s no radical change in stress testing, no radical changes in levels of capital,” Alix said. “It is consistent directionally with the changes the Fed has made or proposed since [Vice Chairman for Supervision Randal] Quarles came in — that being more relief for smaller institutions … and somewhat more real scrutiny for the largest institutions.”

In fact, there are several aspects of the proposals that the largest Wall Street banks will likely protest. First among those objections is the way that both proposals enshrine the G-SIB surcharge into other regulations.

G-SIBs have objected to the surcharge since it was first proposed almost three years ago. The surcharge not only is applied in its entirety to banks’ common equity Tier 1 capital ratio for the stress tests, but is also directly correlated with its eSLR.

The changes to the stress testing regime also leave little relief for the biggest banks. While the quantitative objections are eliminated, the Fed retains its ability to raise qualitative objections for most of the biggest banks, and those are the objections that banks have had the most trouble with in recent years.

Kuntz of Lowenstein Sandler said she would not be surprised if the big banks raise objections to the proposals.

“In general, the banking industry was looking for rollbacks of Dodd-Frank, and this doesn’t do that at all,” she said. “The report talks about the progress that’s been made, so I think in general the banking industry might respond by saying, ‘This doesn’t really do much for us.’ ”

Wright said that even the changes to the eSLR — which presumably would benefit the G-SIBs by effectively reducing their enhanced leverage requirement — are unlikely to result in meaningful capital relief. The way that the capital requirements interact, he said, is such that banks would have a hard time finding a way of gaming one standard without running afoul of another.

“You’d really need a very big calculator to figure out what the interactions are with these new pillars of capital requirements,” Wright said. “It really remains very complex as firms try to understand how to optimize across all the standards.”

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Minimum capital requirements Risk-based capital rule Stress tests GSIBs Jerome Powell Daniel Tarullo Federal Reserve