Fed plowing ahead with stress tests. But should it?

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WASHINGTON — As the coronavirus pandemic puts pressure on banks to aid financially strapped customers, lobbyists, analysts and even some critics of the industry are pushing the Federal Reserve to suspend stress tests for the largest institutions.

The Fed announced Tuesday that institutions will still be required to submit their capital management plans by April 6 for the Comprehensive Capital Analysis and Review, the central bank's primary stress test for assessing how the largest banks' would perform under severe economic shock.

But many observers argue this year's test is irrelevant. While the agency signaled it will use test results to gauge how banks are responding to the pandemic, it showed no sign of changing the economic scenarios under which banks are tested. Those scenarios include the strong economic conditions at the end of last year, and a "severely adverse" scenario that is still not as bad as the current turmoil.

“CCAR is irrelevant because the assumptions in CCAR have already been overtaken,” said Karen Petrou, managing director at Federal Financial Analytics. “Rolling back CCAR should not be viewed as a regulatory relief. It’s a reality test.”

As economists predict a severe recession or worse from the COVID-19 outbreak , industry observers are suggesting that banks’ time would be better spent on lending or offering loan modifications to struggling consumers.

“First off, it is taking an enormous amount of resources … to report,” an industry lobbyist, who spoke on the condition of anonymity, said of the test. “We should be … working on what we’re doing for employees, what we’re doing for [the] market, what we’re doing on liquidity. … That is much more important than filing a CCAR stress test.”

Industry representatives have made several calls for deregulatory actions by Congress and the regulators to focus on helping consumers who have been laid off or missed paychecks due to businesses shutting down. The agencies have responded with numerous measures to ease banks' regulatory burden, including a plan announced Friday to delay any capital impact from the new Current Expected Credit Losses standard for up to two years.

But neither the agencies nor lawmakers, in the Senate's $2 trillion stimulus plan, have provided relief from CCAR. A separate category of assessment mandated by Congress in 2010 known as the Dodd-Frank Act Stress Tests has also not been suspended.

The CCAR test uses two scenarios: one dealing with normal economic conditions, the other based on severe stress to the financial system. For the 2020 test, the baseline scenario is based on yearend 2019 conditions, envisioning GDP growth of 1.75% and an unemployment rate of 3.25%. The latter scenario envisions a severe global recession highlighted by an 8.5% drop in GDP and 10% unemployment. Yet observers say the economic fallout from the pandemic could be even more severe.

Ed Mills, a policy analyst at Raymond James, noted that the U.K. has already suspended this year's stress test. He said it makes little sense to put banks through a simulation of severe market stress when that is what is occurring.

"We are getting the ultimate stress test and it’s not a test," Mills said. "It’s a real-world test, not a theoretical scenario.”

But others countered that a stress test now is even more important to check on the U.S. banking system’s health when institutions are under pressure to help businesses and customers that are hurt by the virus fallout.

“It’s more necessary than ever, because there’s no telling where things are going to go,” said Brandon Barford, a partner at Beacon Policy Advisors. “However, it’s entirely plausible that things do go wrong in other places in the economy and then it’s probably a good idea for the central bank to know just how much stress the financial institutions can withstand.”

While the Fed did not signal any structural changes to the this year's stress test, the statement earlier this week did indicate that the central bank will monitor how banks are withstanding the current shocks.

The CCAR capital "plans will be used to monitor how firms are managing their capital in the current environment, planning for contingencies, and positioning themselves to continue lending to creditworthy households and businesses," the Fed said.

Ian Katz, a director at Capital Alpha Partners, said that a decision by the Fed to forgo the CCAR would send a bad signal to the market about the state of the banking system.

“I think it can be useful to the Fed to go ahead with the exercise and the banks themselves can show that they are in solid shape,” Katz said. “If they did the opposite and said they were suspending them, then that might raise concerns.”

Barford noted that the Fed could still give banks some leeway within the current CCAR framework.

“I think the regulators are going to be entirely reasonable and understand that we’re in the middle of a crisis here,” said Barford. “I wouldn’t think they would be more punitive than they would have otherwise. … They want to identify potential problems and try to get them fixed. They are much less concerned about making a punitive measure to limit the business practices of financial institutions.”

If the Fed doesn’t suspend the CCAR, Petrou said it could determine that additional bank holdings, like reserves, would be counted as capital in the tests this year.

But bolstering the calls for the Fed to halt stress tests is support from market critics who typically call for tougher regulations.

Marcus Stanley, policy director at Americans for Financial Reform, said CCAR is not a good indicator of a bank’s ability to weather an economic downturn at the moment.

“The CCAR has become excessively hypothetical and unrealistic and resistant to change and inflexible and that makes it not useful in this environment,” Stanley said.

He said he would support a suspension of CCAR if the Fed took other measures to require banks to free up resources to help the broader economy.

“I would say that the Fed should be banning all capital distributions,” Stanley said. “Given that we need such a ban, if there was such a ban, then the stress tests would not be so useful and I could definitely see an argument for canceling. … This is a situation where the banks need to be reserving all their loss absorbency [and] building up new loss absorbency if necessary."

Hannah Lang contributed to this article.

This article originally appeared in American Banker.
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Stress tests Risk management Capital requirements Coronavirus Federal Reserve Regulatory relief Capital requirements