Fed Eyes Higher Stress Test Capital Levels for Biggest Banks

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WASHINGTON — Two Federal Reserve governors said Thursday that the central bank will likely require the biggest banks to apply their capital surcharges in order to pass the annual stress tests — a standard that could be costly for some institutions to meet.

"It is likely, I believe, that we will incorporate the full amount of the surcharges into the post-stress capital requirements," Fed Gov. Jerome Powell said during a question-and-answer session at a conference here. "It is also likely that it will not be a dollar-for-dollar increase in the capital requirements. It will be a substantial increase in the requirements, but there will be some offsets."

His comments came after Fed Gov. Daniel Tarullo, who chairs the board's Supervisory Committee, said in an interview with Bloomberg TV that those "offsets" effectively mean a relaxation of some assumptions that have been built into the Fed's Comprehensive Capital Analysis and Review. Those provisions were meant to capture some of the same unknown or unknowable risks that are more methodically considered in the surcharge rule, which applies to the eight largest U.S. banks.

"There are some things that have been put into the stress tests over time that are really quite conservative assumptions that were meant to take into account some of the same factors," Tarullo said. "Now that we're doing that in a more explicit way … some of those things that we put in place before might be adjusted as well. So even though it will be a significant increase, it won't be dollar for dollar."

One of the biggest questions looming over the Fed's surcharge for global systemically important banks, or G-SIBs, is how it might be applied to the stress tests. That rule, finalized in July, requires the G-SIBs to hold between 1% and 4% more capital as a buffer to counteract their systemic risk. The eight U.S.-based G-SIBs are placed into different tranches of risk based on factors such as their size, complexity and interconnectedness, but with a particular emphasis on the risks posed by overreliance on short-term wholesale funding.

Under CCAR, banks must meet various minimum capital standards under a series of hypothetical economic conditions. This "post-stress" minimum capital requirement is, for many banks, the binding constraint of the Fed's capital regime, since banks that are found not to meet those minimum standards are barred from paying dividends.

There had been some ambiguity over whether or to what degree the Fed would effectively raise the CCAR minimum post-stress capital requirements through its application of the GSIB surcharge. Tarullo said in November that "the incorporation of some or all of the capital surcharge as a post stress minimum" was but one of several options the Fed was considering for strengthening the CCAR process and financial stability in general. Tarullo and Powell — who sits on board's the Supervisory Committee — left little ambiguity Thursday about the direction the Fed intends to go.

Some industry observers have raised concerns that the cumulative impact of the post-crisis regulatory regime as imagined by the Fed and other bank regulators is hastening the shift of financial services away from the banking sector and toward the less-regulated "shadow banking" sector.

Karen Shaw Petrou, managing partner at Federal Financial Analytics, said her firm has recently completed work on a lengthy analysis of available research that suggests that the migration away from the banking sector may affect the Fed's ability to transmit monetary policy objectives into the financial system. The Fed's tools apply to banks, Petrou said, but if banks are no longer the dominant venue of financial transactions, the Fed's monetary policy objectives become harder to realize.

"The paper demonstrates that, with regard to the macroprudential regulation and with regard to monetary policy transmission … the market is not waiting for the Federal Reserve to finish its run-through all the footnotes," Petrou said. "There are very disturbing signs evident in the array of Federal Reserve and BIS research we cite that warrant immediate attention."

During the interview, Tarullo said that it was "appropriate to step back a bit" and consider whether financial markets were migrating away from banking, as well as whether more needed to be done with respect to ending "too big to fail" and whether the costs of new rules exceed their benefits.

"At the Fed, our division of financial stability is constantly monitoring" the migration of markets away from banks, Tarullo said.

Powell, for his part, said he was not necessarily convinced that fixed-income liquidity has dried up or that the biggest banks remain "too big to fail" — hazards frequently attributed to the post-crisis regime. But he said the time had probably arrived for the Fed and other regulators to take a closer look at the cumulative effects of the Dodd-Frank and Basel rules and see if there are better ways of achieving the objectives of safety and soundness.

"It is appropriate for us to take a step back and think about the harmony of these things and [whether there are] ways to achieve the same things with less burden," Powell said. "We are in fact turning our attention more to that now."

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