The familiar fingerprints on the Fed's stress test changes
WASHINGTON — While the winds may be changing at most banking agencies since President Trump’s election, the Federal Reserve Board's plans to update and revise its stress testing program is one area where there is a lot of continuity between the prior administration and the current one.
But in contrast to other initiatives at other agencies, where Trump appointees are poised to go in a significantly different direction than their Obama-appointed predecessors, the Fed's stress test work appears aligned with the vision set out by previous leadership.
Observers say that for all the uncertainty generated by the change in administrations, they expect that any final package of stress test changes will probably bear more than a passing resemblance to a plan outlined by former Fed Gov. Daniel Tarullo, an Obama appointee, for reasons of both practicality and expediency. For example, the Fed's recent move to be more transparent about its stress test methodology is consistent with steps advocated for by Tarullo.
“I don’t believe the Fed was going to scrap things because they were the last guy’s ideas,” said Aaron Klein, policy director at the Brookings Institution’s Center on Regulation and Markets. “The Fed, more so than other regulators, will look at things more continuously.”
To be sure, regardless of which party held power, the Fed was always likely to revise its stress tests over the coming years after gathering input on what has and has not worked with the tests thus far. It was just a question of how the central bank would make those changes and when.
Tarullo, whom President Obama appointed to the board in 2009 and who headed the Fed's supervisory committee, had sketched out the contours of what he envisioned as a retooled Comprehensive Capital Analysis and Review stress test during a speech last year. The plan would include revisions to a minimum capital requirement, removing a qualitative assessment for all but the largest banks and broadening macroprudential consideration for annual stress test scenarios.
Since the election, Republicans in Congress and some in the banking industry have also targeted CCAR, although with more extreme changes in mind — envisioning a pared-down, or even eliminated CCAR program.
But for the time being, at least, the Fed's current and future leaders seem to be incorporating many elements of Tarullo's blueprint, moving forward with a plan to make the stress test process more transparent while avoiding any wholesale makeover of CCAR.
Randal Quarles, the Fed's vice chairman for supervision, and Gov. Jerome Powell, Trump’s nominee to chair the Fed, have both said that making the stress testing program more transparent is a top priority. To that end, the agency last week published a set of proposals that would open up more of the agency’s internal stress model methodology to scrutiny and would publish additional aggregate results, giving bankers a better idea of how portfolios are assumed to perform in stress conditions. Those changes would be implemented over the next several stress test cycles and would not affect the 2018 stress tests.
But when it comes to plans for the program in the medium- to long-term, Quarles and Powell have been vague. Powell repeatedly cited stress testing as among the Fed’s major post-crisis policy accomplishments, suggesting that CCAR would not be eliminated. But he also said during his confirmation hearing last month that the agency is reviewing its programs, including stress testing, because it is “our obligation to … [make] sure that what we did makes sense.”
Quarles, speaking at an event in New York earlier this month, spoke at length about his views regarding the stress tests’ lack of transparency and his views on how to fix it. He said he is largely untroubled by the argument that greater transparency will cause banks to “teach to the test.” But he expressed concerned that the necessity of having a single regulatory model dictate the outcomes of the stress tests makes it imperative that that model remain somewhat secretive, at least in the near term.
“I don’t think it is in any way permanently solved by lack of transparency,” Quarles said. “Until we have a better solution we will have some lack of transparency. All that said, I think we can and we will be much more transparent than we have been in the past.”
Karen Shaw Petrou, managing partner at Federal Financial Analytics, said that the focus on transparency is in large part a political choice, or at least one informed by political pressures. She said these changes are meant to give the agency more breathing room to make whatever future changes it sees as appropriate without unwanted Congressional mandates.
“The big push is clearly on the transparency issue, it’s part of the reason of the political fire, “Petrou said. “The Fed is in defense mode to try to prevent the Hill from changing the stress test in ways they don’t want.”
Still, Tarullo’s blueprint and the priorities laid out by Trump's Treasury Department in its June report on bank regulations are in essence different playbooks.
Whereas the administration wants dramatic changes to CCAR's scope, Tarullo’s plan was largely focused on modifications to improve the program. His roadmap centered on establishing a “stress capital buffer,” which would replace the various capital requirements that banks must currently meet. The stress capital buffer would be comprised of a baseline common Tier 1 capital level of 4.5%, plus the applicable capital surcharge on Global Systemically Important Banks, and a variable additional buffer based on each individual bank’s performance in the previous year’s stress test.
Tarullo had called for some other changes that the Fed has either already unveiled or are in the works. The Fed in January voted to scale back the qualitative aspects of the test for banks with less than $250 billion in assets and less than $75 billion in nonbank activities, which was another of Tarullo’s suggestions.
He had also called for some changes to the Fed’s stress scenarios, saying they should be able to incorporate a wider range of macroprudential data, such as revising the unemployment rate to take into account the baseline unemployment rate at the moment and replacing housing costs with a variable for personal disposable income. The first suggestion made its way into the Fed's proposal on transparency last week.
The Treasury report does not mention a stress capital buffer, but instead calls on the Fed to eliminate the qualitative assessment altogether. The report also calls on Congress to raise the $50 billion asset threshold for stress testing to an unspecified, but higher, threshold, and proposes that CCAR be a biannual rather than annual exercise.
Some of those proposals are part of a Senate regulatory relief package that is poised to pass. The bill would raise the asset threshold from $50 billion to $250 billion, effectively eliminating more than a dozen banks from stress testing altogether. The package would also change the Dodd-Frank Act Stress Test from semiannual to “periodic,” thus giving the Fed greater discretion over how frequently it would conduct that test. The bill follows another Treasury suggestion in eliminating the “adverse” scenario from stress testing, leaving banks to only comply with the baseline and severely adverse scenarios.
Isaac Boltansky, an analyst at Compass Point Research & Trading, said the most likely result is that the Fed will take its cues from both the Tarullo plan and the priorities of the administration and Congress. The two playbooks are not necessarily incompatible. But how those plans intersect — and when — is anyone’s guess, he said.
“Just from a market perspective, there’s a belief that that final Tarullo speech will be put into practice over time,” Boltansky said. “But there’s still real questions as to where Quarles and Powell will work together, how long it will take to implement meaningful stress test changes, [and] how the Senate bill will impact that.”
Part of the reason that the market views the stress capital buffer idea as still having life is it has some qualified support from industry. The Clearing House Association, a trade group that represents many of the largest banks subject to stress testing, said in a statement that the group supports the idea of a stress capital buffer, albeit with some objections to the way Tarullo would have incorporated the G-SIB capital buffer.
“The Clearing House supports the goal of the SCB framework of simplifying the capital requirements, but also sees the prospective change as an important opportunity to correct flaws in its component parts — stress tests and the capital surcharge required of large, international banks — that will otherwise be amplified,” the Clearing House said.
Mike Alix, a partner and the Financial Services Consulting Risk Leader at PricewaterhouseCoopers, said the parts of the Tarullo plan that resolve some of the redundant and less efficient aspects of the early iterations of the test are likely to be adopted — particularly those affecting smaller institutions. He also said he thought the prospect that the qualitative assessment gets eliminated from CCAR altogether will probably take several years, but ultimately is “inevitable.”
“I think Tarullo had in mind a package of changes that were a package that would cement stress testing in the capital regime and address some of the real problems or friction they had learned about in the early years of CCAR,” Alix said. “The new folks may be more inclined to allow relief rather than following through with the whole package, but time will tell.”
Alix said the prospects of the Fed winding down the CCAR program to the point where it is just another part of the agency’s supervisory program is less certain, but still possible in the long-term. In another crisis, the Fed may decide that publishing damaging results of a bank’s stress test is a risk not worth taking, he said.
“They may be worried that, if and when that cycle turns and banks lose money, that the public objection could exacerbate a problem, and they don’t want to do that,” Alix said. “Better to have any concerns they have about capital planning and risk management discussed behind closed doors.”