WASHINGTON — The Federal Reserve Board is contemplating a sweeping new vision of the future of the central bank's hallmark supervisory stress testing program — a vision that involves major concessions to midsize regionals and puts added pressure of the largest and most systemically risky banks.
In a speech Monday, Fed Gov. Daniel Tarullo said the Fed plans to drop the qualitative assessment for most banks with assets of more than $250 billion but incorporate the entirety of the Fed's surcharge for global systemically important banks into the capital minimums that banks have to retain.
While those two measures had been widely expected, Tarullo also unveiled a new "stress capital buffer" that will be added to capital minimums — a concept that effectively makes banks retain the amount of capital that they lost under the previous year's severely adverse scenario.
Karen Shaw Petrou, managing partner at Federal Financial Analytics, said the proposals — most of which would not take effect until 2018 at the earliest — are the culmination of a series of rules that the Fed has either adopted or proposed that penalize the biggest banks. She likened the rules to running hurdles in track and field, except each subsequent hurdle is even higher than the last.
"The number of hurdles over which they have to jump is increasingly higher," Petrou said. "It's a towering pyramid of increasingly binding constrains the bigger you are."
Rob Nichols, the president and CEO of the American Bankers Association, echoed that concern, saying that the incorporation of the GSIB surcharge into the capital rules might stand in the way of the intended purpose of the buffer.
"We are concerned that it may not preserve the proper function of a capital buffer — to absorb losses in a stressful period — and instead could impose unnecessarily high capital requirements that would make it harder for banks to make loans that help our economy grow," Nichols said. "This tailored approach is a welcome step, but the statute remains an impediment to truly differentiating between banks based on the complexity of their business models and the true risk they represent to the economy."
The Fed last year finalized its GSIB capital surcharge rule, which applies to the eight largest banks: JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Morgan Stanley, Goldman Sachs, State Street and BNY Mellon. It sets an additional buffer to the banks' capital requirements of between 1-4% based on size, though the largest banks — JPMorgan and Citi — are set at 2.5% and 2% respectively.
More recently, the Fed and other bank regulators have proposed a net stable funding ratio that doles out significantly more onerous standards for so-called "advanced approaches" banks — that is, banks with more than $250 billion in assets or at least $10 billion in foreign exposure. The regulators took the same tack when proposing their executive compensation rules and process for setting a countercyclical capital buffer as well.
Tarullo had hinted in June that the stress tests would likely incorporate most if not all of the GSIB surcharge into the minimum capital requirement. He noted Monday that the increase in capital requirements for the GSIBs would be offset by roughly half through changes elsewhere in the capital rules — namely not requiring banks to retain two years of capital distributions.
Ernest Patrikis, partner with White & Case and former first vice president and general counsel of the Federal Reserve Bank of New York, said the impact of the rules leads to a sort of de facto policy of breaking up the biggest banks.
The Fed would be better served by setting a clear line in the sand, he said, rather than subjecting U.S. banks to death by a thousand cuts — cuts that it appears foreign banking regulators are not so eager to inflict on their banks.
"What is our national policy regarding large banks? Why don't we just enunciate what we think the policy is?" Patrikis said. "As opposed to [regulating] a little bit here, a little bit there. You want to break up? Let's break up. You want to say, 'This is the maximum size'? Then this is the maximum size."
Tarullo said that the cumulative impact of the board's proposed rules and the changes he floated Monday could potentially lead the largest banks to decide to change some of their business lines or even change their structure. But he said that was not a goal — the goal, he said, is to promote financial stability.
"That's a judgement that they need to make, and some of them and perhaps many of them may make these kinds of judgements, and if that entails changes to the structure of the company by the boards and management of those firms … we do recognize that may be an outcome," Tarullo said. "But we haven't put it in place to say, 'We want these steps taken by these firms.'"
In addition to putting greater onus on the biggest banks, the measures also give a boost to midsized regional banks with limited international exposure. Petrou said the exemption of banks with between $50 billion and $250 billion from the qualitative CCAR examinations is a major benefit, since most of them handily pass the quantitative requirements and the change "gives them a far better chance of passing the test." The Fed issued a proposal outlining that exemption Monday, which is slated to be in effect for the 2017 stress testing cycle.
Jaret Seiberg, managing director of Cowen Group, said in a research note that the effect of reducing the requirements for regional banks while adding more for the biggest banks is to signal a clear preference for smaller banks.
"All of this will make it harder for the biggest banks to pass CCAR, which means it will drive up their capital requirements," Seiberg said. "This is why we see Tarullo's comments today as broadly supportive of our theme that the policy environment favors the regional banks over the megabanks."
How banks respond to the proposal remains unclear. A banking industry group called the Committee on Capital Markets Regulation issued a legal white paper earlier this month arguing that the lack of disclosure on CCAR's internal models and the formulation of the stress scenarios violate the Administrative Procedure Act, hinting at a possible lawsuit if the stress testing program becomes too onerous.
Patrikis said that the industry may be more emboldened to take the Fed to court based on Tarullo's proposal.
"It's getting more and more onerous, and you may want to see if you can get some pushback on those provisions," Patrikis said.