Fed’s new capital buffer refocuses on risk

Low-risk activities and larger management buffers likely to become more attractive

The US Federal Reserve’s proposed revisions to its capital framework would make risk-based capital requirements more volatile, bank analysts say, intensifying prudential and shareholder focus on risky assets while improving the comparative appeal of low-risk activities.

The proposal, released on April 10, would replace the capital conservation buffer – currently fixed at 2.5% – with a ‘stress capital buffer’ equivalent to a bank’s worst-case losses in the Fed’s annual Comprehensive Capital Analysis and Review (CCAR).

“The requirements will vary from year to year, based on the change in the balance sheet of the bank and the design of the scenarios,” says Michael Alix, financial services advisory risk leader at PwC. “If the scenario is harsher, you’re going to need to hold more capital.”

Each bank’s stress capital buffer will be in effect from October 1 each year, through to the end of the following year’s CCAR. The new buffer will be floored at 2.5%, but the maximum will be uncapped. In practice, this means banks will derive no benefit from the Fed’s decision to end the practice of quantitative fails for CCAR.

“They got rid of the quantitative fail, but they didn’t really get rid of it because the stress capital buffer is determined by the Fed models in exactly the same way CCAR has always been run,” says Til Schuermann, a partner at Oliver Wyman.

In fact, folding stress testing into the capital regime increases the potential penalties for heavy capital depletion in the severely adverse stress scenario. Under CCAR, banks had an opportunity to correct a quantitative fail immediately or face limits on dividend payouts. The consequences of breaching the capital conservation buffer are much more severe, including a full suspension of common dividends and stoppers on discretionary management bonuses.

Analysts argue this is likely to make management and boards much more conservative in risk managing their balance sheet and capital ratios. Stuart Plesser, a senior director in the financial institutions team at S&P Global Ratings, says banks typically hold a buffer of 50 basis points over their capital requirement, and could regard anything in excess of that as potentially eligible for capital payouts or buybacks.

“The interesting part will be what they are going to manage to now. It could still be the 50bp off a higher capital ratio minimum, but the problem they are facing is that their capital ratio minimums are going to change on a yearly basis, when before they were static and they knew what they were… So they might hold a bigger buffer because they might not be wanting to suddenly build capital up very quickly if their minimum capital ratio changes significantly,” he says.

If the proposals go into effect, the Fed estimates aggregate capital requirements will increase by between $10 billion and$50 billion for global systemically important banks (G-Sibs), and decrease by $10 billion to$45 billion for non-G-Sibs.

The 34 banks subject to CCAR in 2017 saw their capital ratios decline by 3.3% on average under the Fed’s severely adverse scenario. However, the dispersion around the mean was significant, with Morgan Stanley recording an 840bp drop in capital, while Bank of New York Mellon saw its capital fall by just 110bp in the worst-case scenario. Goldman Sachs and Citi also saw large declines of 610bp and 520bp, respectively, in their CET1 ratios in last year’s CCAR.

But analysts say the proposal’s realised impact on G-Sib capital ratios is unpredictable due to changes in the CCAR methodology the Fed is introducing in the same package. Instead of assuming dividend payments across all nine quarters of the stress scenario, banks must now prefund only four quarters. The nine-quarter assumption had been criticised in the past as excessively conservative and Fed officials had partially acknowledged the validity of these concerns.

If their binding constraint was the leverage ratio, and it becomes the risk-based, they will probably be more willing to take on less risky assets than they were before
Stuart Plesser, S&P Global Ratings

The cut to four quarters “could provide as much as 50bp or 100bp in capital relief”, according to a stress-testing expert at a consulting firm. However, other analysts point out the benefit will vary bank by bank, depending on whether the maximum capital burn-down occurs before or after the fourth quarter in the scenario.

The more substantial change proposed is the switch from a dynamic to a static balance sheet assumption. Again, the exact impact is unpredictable, depending on how far capital depletion under the existing CCAR methodology is due to balance sheet growth. But Plesser believes the switch seems to save banks roughly between 70bp and 100bp of capital.

Most importantly, a static balance sheet will reduce the effects of the leverage ratio stress test. Unlike the risk-based asset measure, leverage exposure increases one-to-one as the balance sheet grows, so removing the growth assumption makes the leverage ratio test less likely to bite.

According to S&P calculations, State Street and Morgan Stanley were constrained by the Tier 1 leverage ratio in the 2017 CCAR, so they are likely to benefit the most from the switch to a static balance sheet assumption. The reduced intensity of the leverage ratio test will also bring the risk-based measures into sharper focus from a capital management perspective.

“If their binding constraint was the leverage ratio, and it becomes the risk-based, they will probably be more willing to take on less risky assets than they were before – repo business, deposits – and be a little more careful of how much risk-based assets they will be willing to take on because the risk-based capital ratio will likely become their binding constraint,” says Plesser.

While the switch will ease the burden of CCAR and the new stress capital buffer, a second consultant who has advised US banks on capital management says the revision seems inconsistent with the Fed’s wider objectives: a dynamic balance sheet allows banks to integrate the supervisory stress test with their business planning, but a static balance sheet breaks this link.

“The Fed expects the capital plans should be linked to the business plan. There is no business plan that assumes static balance sheet or zero growth, so that is counterintuitive to CCAR. It is a simplification that makes results more comparable, but it surprised me,” says the consultant.

Editing by Tom Osborn

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