Fixing the roof while the sun – wait, is that rain?

Grade inflation is the tendency to award progressively higher scores for test results of equal merit. The result (typically according to critics who graduated some years earlier) is a steady deterioration in academic standards at schools and colleges, rather than the reported improvement. 

It’s also a charge levelled at the Federal Reserve in the context of the Comprehensive Capital Analysis and Review (CCAR), the central bank’s gold-standard stress test for large lenders. To pass, banks have to hurdle a minimum Common Equity Tier 1 capital ratio threshold of 4.5% under stress and a leverage ratio of 4%.  

The class of 2019, made up of 18 banks, breezed the tests, reporting a median stressed CET1 ratio of 9.6%. The same participants last year posted a median ratio of 7.9%. 

What’s strange about this is that the CCAR is supposed to get tougher as the US economy improves; countercyclicality is built into the Fed’s stress scenario-designing policy. So, is the regulator easing off on its charges like an indulgent professor? And what does this mean for banks’ resilience?

The industry’s response to the first question is a resounding ‘no’. The Bank Policy Institute, a trade body, says banks have improved their CCAR performances because they have shed assets that turned to junk during the global financial crisis, the event upon which the Fed’s stress scenarios are based. To extend the grade inflation metaphor, the tests haven’t been dumbed down, the students have genuinely gotten smarter.  

If this is true, then higher post-stress CET1 ratios show banks are tougher now than in years past and better able to withstand a crisis. But this in turn invites another question: from this position of strength, should banks be pushed to set aside additional capital for a rainy day? 

The Fed could achieve this by activating the countercyclical capital buffer (CCyB), a tool introduced by the Basel Committee on Banking Supervision that forces banks to stockpile reserves during good times so they can be used to support lending when things turn sour. 

Switching on the CCyB is a hot topic at the US regulator. Boston Fed president Eric Rosengren has said the benign US economy means it’s an “ideal time” to switch on the capital buffers. But on the flipside, governor Randal Quarles, a member of the Fed’s board, supports a 0% buffer. The board as a whole affirmed a 0% setting in March. 

On the other side of the Atlantic, 13 EU member states have implemented or announced a non-zero buffer, but the consensus is skin-deep: actual buffer levels range from 2.5% in Sweden, to 1% in the UK and 0.25% in France. 

These disagreements within and between countries illustrate an uncomfortable truth about the buffer. There is no science in its application, yet – some nations will switch it on too early, and some will switch it on too late.