Using the term “deregulation” to describe the Federal Reserve’s plan for simplifying stress tests that determine how much money banks can return to shareholders is technically correct. It’s also more than a little misleading.
When businesses talk about deregulation, they generally assume that curbing or eliminating an element of government oversight will make their operations less expensive, thus boosting their bottom lines.
Simplified stress tests won’t necessarily do that. Some lenders might actually have to set aside more capital reserves than they do under existing rules designed to prevent a recurrence of the 2008 financial crisis, a point the central bank itself concedes.
While the Fed’s proposed rule change encompasses dozens of pages, the core involves replacing one of the components of existing liquidity standards — a requirement that lenders have liquid capital equal to a flat 2.5 percent of outstanding risk-weighted loans — with a more tailored “stress capital buffer” where the percentage is determined by the company’s stress test performance. A separate buffer that requires banks to hold capital equal to total assets — without regard to risk — would no longer factor into passage or failure.
“Banks opposed the stress capital buffer out of worry that this buffer would vary from year to year,” said Jaret Seiberg, an analyst with Cowen Washington Research Group. No bank wants to risk failure, so they “will need to keep a bigger buffer to ensure they don’t,” he said.
At JPMorgan, the largest U.S. lender, replacing the existing rule with the stress capital buffer would have widened the capital requirement by 150 basis points in 2015 and 50 basis points in 2016, the bank pointed out in its quarterly earnings report.
There would have been no difference in 2017, said Chief Financial Officer Marianne Lake, but this year’s stress test is harsher, and its impact remains to be seen. The new buffer is equal to the percentage decline in the bank’s most liquid capital under the annual stress test’s “hypothetical severely adverse scenario,” the harshest of the theoretical economic shocks used to measure safety and soundness.
“The obvious challenges with the current proposal include the significant volatility and the opacity in the Fed’s results,” she said. “There will potentially be a need for larger management buffers if it is necessary to accommodate significant volatility.”
Although the bank’s required capital buffer would likely be higher than the existing 2.5 percent if the proposals are approved, JPMorgan supports simplification generally and agrees that “firms should be required to hold adequate capital to withstand severe stress calibrated to firm-specific exposures and risks.”
The calculations are crucial to investors, since they determine the size of dividend payments and stock-buybacks over the coming year. The Fed’s announcement of stress-test results each June is typically followed by a cascade of dividend increases along with billions of dollars in share repurchases.
To deliver those payouts, U.S. banks tested by the Federal Reserve have been forced to substantially increase their capital buffers since the first round of reviews in 2009.
The tests were begun against a backdrop of voter outrage over billions of dollars in government bailouts that propped up financial institutions such as Bank of America, Citigroup, and American International Group while consumers lost their homes and unemployment spiked to 10 percent.
The common equity capital ratio, a measure of lenders’ most liquid capital, has more than doubled from 5.5 percent in the first quarter of 2009 to 12.1 percent in the fourth quarter of 2017, according to the central bank. That reflects an increase of more than $720 billion.
As regulators review the rules that prompted the stronger system, some based specifically on the Dodd-Frank finance reform law of 2010, the goal is “to understand which reforms are working well” and which ones can be improved to reduce regulation and improve efficiency without imperiling the system, said Randy Quarles, whom President Trump appointed as the central bank’s vice chairman for supervision.
“If we identify rules that are not working as intended, we should make the necessary changes,” he said. “With the benefit of hindsight and with the bulk of our work behind us, now is a natural and expected time to evaluate the effectiveness of that regime.”
At Wall Street firm Morgan Stanley, CEO James Gorman believes building capital requirements around the relative strength or risk of assets makes sense.
Failing to consider the difference might prompt some companies to focus on higher-risk — and higher-profit — loans, since they must keep the same buffer regardless, he noted.
“That’s clearly not an outcome that regulators here or anywhere in the world would want,” he said.
Morgan Stanley won’t be any worse off under the proposed scenario than it is now, he said, but “whether and how much better off, I don’t want to pre-judge.”
“Bank of America generally views the change as a sensible one,” Chief Financial Officer Paul Donofrio said, though he noted the fluctuations in severity of the Fed’s yearly stress tests.
“The question,” he said, is whether that will “introduce uncertainty, and is that going to force all these banks to have more of a buffer?”
