The Committee on Capital Markets Regulation (the “Committee”) strongly supports the use of regulatory stress tests to ensure that banks have sufficient capital to absorb losses under adverse economic conditions. The severe economic effects of COVID-19 have further heightened the importance of stress testing to ensure the stability of the banking system. In this statement, the Committee sets forth recommendations for the Federal Reserve Board’s (the “Fed”) Fall 2020 stress test.
Part I of the Committee’s statement describes the Fed’s 2020 Dodd-Frank Act stress test (“DFAST”), COVID-19 sensitivity analysis and the temporary restrictions on banks’ distribution of capital to shareholders. We also review recent actions by the Fed, Federal Deposit Insurance Commission (“FDIC”) and Office of Comptroller of the Currency (“OCC”) that have clarified that a bank may draw down its “capital buffers,” including the stress capital buffer (“SCB”) and the global-systemically important bank surcharge (“G-SIB surcharge”). However, a bank that draws down its capital buffers is then subject to limitations on its capital distributions. We then review the Fed’s Fall 2020 stress test and the lack of clarity as to the effects of the Fall 2020 stress test on the SCB and temporary restrictions on banks’ distribution of capital to shareholders.
Part II of the Committee’s statement sets forth recommendations for the Fall 2020 stress test. First, banks should not be automatically required to recalculate their SCBs based on the results of the Fall 2020 stress test. Instead, consistent with the Fed’s capital framework and principles, the Fed should use the results of the Fall 2020 stress test to inform its supervisory discretion to require banks to revise their SCBs. However, the Fed should use extreme discretion in increasing the SCB for any banks due to the Fall 2020 stress test, as increasing capital requirements during the current economic environment can be procyclical. Indeed, Vice Chair Quarles and Chair Powell have acknowledged the importance of not increasing capital requirements during stressed economic conditions.
Second, once the Fall 2020 stress test is complete and the results are public, the Fed should end its temporary restrictions on capital distributions, as the Fed can now rely on the Fall 2020 stress test to make decisions as to the minimum capital levels for covered banks.
Third, in our view, the purpose of the Fed’s Fall 2020 stress test should be to determine whether capital requirements need to be adjusted to take into account the real economic situation. However, the severely adverse economic scenario in the Fall 2020 stress test includes projections for GDP and unemployment that are much more negative than projections by economists. Such stress scenarios are appropriate for the Fed’s annual stress test but should not be the focus of the interim Fall 2020 stress test. The inconsistency of the scenarios with the real economic situation is further reason for the Fed to exercise extreme discretion in increasing the SCB for any banks due to the results of the Fall 2020 stress test.
Fourth, although banking regulators have notified banks that they may draw down their capital buffers, we believe that banks are unlikely to do so because of the regulatory restrictions that would apply to their capital distributions. We therefore recommend that the Fed allow banks to draw down a share of their capital buffers (e.g. 10-15%) before subjecting banks to restrictions on their capital distributions. In other words, during the COVID-19 pandemic, the effective SCB and G-SIB capital surcharge should be temporarily relaxed to 85-90% of their full levels.
Finally, we note our longstanding and separate recommendation that the Fed should provide full transparency of its stress testing model as doing so would enhance the quality of the stress test model and provide the public with increased confidence in the stress testing process and resiliency of the banking system.
The full statement can be found here.