Will Fed's simpler capital regime be ready before next stress tests?

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WASHINGTON — Despite the Federal Reserve’s goal of finalizing a new simplified capital buffer for large banks in time for their upcoming 2020 stress tests, some industry professionals say its completion may be pushed back to the next round of testing.

The Fed proposed the "stress capital buffer" in April 2018 to streamline its stress test program. Each bank subject to the Comprehensive Capital Analysis and Review would have to meet a unique benchmark, based on its performance, of how much capital to hold in the following year to combat potential market stress.

The Fed is still aiming to complete the rule in time for the upcoming stress test cycle in April, but onlookers say meeting that goal will be increasingly difficult as the date approaches, especially if they include material changes to the buffer in the final rule.

“There are still questions that are up in the air in terms of what policy direction the Fed wants to go on certain specific elements," said Jeremy Newell, a partner in the financial services group at Covington & Burling. Newell added that if there is a "large magnitude of change" from the original proposal, "you would certainly expect the Fed would go through a pretty robust notice and comment process before they finalize it and put it in place.”

Fed Vice Chairman for Supervision Randal Quarles has suggested that the Fed board is weighing a number of changes, some of which could require separate proposals and more notice and comment periods.

In a speech in September, Quarles signaled that the central bank may revise how the proposal dealt with the funding of dividends.

He laid out two potential options for the Fed to choose: raising the minimum SCB level set for all banks above the proposed 250-basis-point threshold, or raising the Fed's countercyclical capital buffer above zero "in normal times." The CCyB is a separate benchmark designed to build banks' defenses when risk starts accumulating in the financial system.

Quarles also questioned the proposal's use of an unweighted leverage ratio as a component in measuring the SCB.

“Let me say that it is my hope to have an SCB framework in place for the 2020 stress tests,” he said in September. “Of course, we will solicit public comment on potential revisions to the SCB proposal through the standard rulemaking process, and I expect that to occur in the near future.”

But if the Fed does go forward with incorporating any of Quarles’ possible changes to the buffer, it’s hard to see how the SCB could be ready for this year’s stress tests, especially if the Fed does solicit public comment on any modifications, said Art Angulo, managing director at Promontory Financial.

“Given that we are in mid-January, and the [stress test] instructions need to go out in early March, I don't think this leaves enough time for them to put this out for comments, absorb the comments and then issue the proposal in final form, so I'll be very surprised if this is effective for the upcoming stress test,” he said.

Banks have likely already started preparing for the 2020 round of stress tests, and are probably operating under the assumption that the final SCB won’t be in place, Angulo added.

Still, some say there is a need for clarity on what exactly banks should expect for the tests. Quarles told Politico last week that the Fed wants to have “a good chunk” of the SCB in place for this year’s tests, but it remains to be seen what that might include.

“Banks want clarity on the 2020 cycle,” said Hugh Carney, the senior vice president of prudential regulation and asset management at the American Bankers Association. “Clarity is important because banks are making decisions about what their portfolios look like, based on their expectations of whether or not it will be in place."

The banks subject to CCAR are likely “watching incredibly closely” to see what elements — if any — the Fed might finalize before the 2020 cycle officially begins, said Newell.

For example, the Fed could enact the broader goal of its stress capital buffer proposal and simplify some capital requirements without touching some of the more complicated aspects.

“I think as a general matter, [the industry] has to operate on the assumption that the status quo will remain in place" for 2020, said Newell. “By definition, you can't prepare for that which hasn't even been articulated at this point, so I think institutions have no choice but to prepare for the status quo.”

However, the industry is generally very supportive of the stress capital buffer — even though the framework of the buffer maintains a surcharge for the global systemically important banks — and is eager to see the buffer finalized.

“Effectively," the stress capital buffer "integrates the point-in-time capital requirements with the stress testing regime, and as a result, it significantly simplifies bank requirements, and so the industry as a whole — the general concept of it — is very supportive of it,” Carney said.

Yet many of the suggestions Quarles laid out in September to revise the proposed stress capital buffer would also be positive for banks, said Angulo.

“Based on Vice Chairman Quarles’ September speech, he would reverse course and now exclude the leverage ratio from the stress capital buffer, and that's a big win for the banks, because the leverage has been a binding constraint for some banks under the stress test,” he said.

Banks also cheered Quarles’ suggestion that the Fed could ultimately exclude the requirement to pre-fund four quarters of dividends from the final rule.

But there are still question marks that some in the industry say need to be addressed in the final rule, including clarity on which of the two options laid out by Quarles — raising the minimum SCB or raising the CCyB above zero — the Fed will choose.

While Quarles told Politico that he prefers the CCyB option, such a method could be much more difficult to accomplish.

“It would, quite frankly, require the Fed to reconsider and re-propose how it has implemented the countercyclical capital buffer, aside from introducing the stress capital buffer,” said Newell. “That would be a much more significant and more complex structural change to how large-bank capital is done in the U.S., and would seem to suggest an even longer and more robust rulemaking process before that could finally be nailed down.”

Meanwhile, raising the floor of the SCB is almost a “painless solution,” said Angulo.

“It will be cleaner in terms of the stress capital buffer proposal to build this floor than to go back and integrate now the stress capital buffer with the countercyclical buffer requirement,” he said. “That would be much more complicated.”

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