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Fed Makes It Easier For Banks To Pass Stress Tests (#GotBitcoin?)

The Fed recently made it easier for banks to pass the stress tests, easing a “qualitative” component of the exam that evaluates banks on factors such as the quality of its internal data and management controls. Fed Makes It Easier For Banks To Pass Stress Tests (#GotBitcoin?)

The Fed is also considering changes that would eliminate the chance banks could fail the second part of the test—which evaluates whether the banks would have enough capital under a hypothetical shock to remain above all regulatory capital requirements—in favor of a continuous capital requirement.

Those changes have sparked concerns from some Democrats, who say the Fed is making the exercise too easy for banks. For the second time ever this year, no firm failed the stress tests.

Annual exam must explore unexpected scenarios or it might fail to prepare financial system for next downturn.

Federal Reserve Chairman Jerome Powell said stress tests of the nation’s largest banks must adapt and keep firms on their toes, or the annual exam could fail to prepare the financial system for the next downturn.

“If the stress tests do not evolve, they risk becoming a compliance exercise, breeding complacency from both supervisors and banks,” Mr. Powell said Tuesday in prepared remarks for a stress-testing conference at the Federal Reserve Bank of Boston.

“When the next episode of financial instability presents itself, it may do so in a messy and unexpected way,” Mr. Powell added. “Banks will need to be ready not just for expected risks, but for unexpected ones.”

The tests must vary from year to year and explore “even quite unlikely scenarios,” Mr. Powell said, warning that too rote an exam could encourage banks to have similar portfolios, making the system more vulnerable to specific risks.

“All banks would look much alike rather than the banking system we want and need, one with diverse institutions with different business models,” he said.

Updated: 11-26-2019

U.S. Banks Cram For Fed Risk Test, With Ripple Effects In Repo

New quarterly data from the biggest U.S. banks suggest that some will need to back away from short-term lending markets by year-end to avoid triggering requirements that they hold more capital.

The data, posted on Friday by the Federal Reserve, showed four of the six biggest U.S. lenders were above or close to thresholds that would increase their capital surcharges.

An easy way to get the scores down would be doing less lending through overnight repurchase agreements and foreign exchange swaps, said analysts who track the filings.

Those markets have experienced stress in recent months. Retreats by lenders would make them more vulnerable.

“If the economic narrative shifts in December, it could have a greater impact than if it were to shift at any other point in the year,” said Josh Younger, a derivatives strategist at JPMorgan who is not involved in the bank’s lending.

Calculations from September data in the JPMorgan Chase & Co (JPM.N) filing, for example, indicate that its score as a Global Systemically Important Bank, or GSIB, was 751, or 21 points above the level at which its capital surcharge would be increased to 4% from 3.5%.

If JPMorgan doesn’t get below 730 it will have to hold another $8 billion of capital, analysts estimated. That would dampen return on equity. The bank has said it will be under the threshold.

The Fed, similar to bank regulators abroad, began imposing GSIB surcharges in 2016. The aim was to make big banks bear the costs to others of their failure and force them to choose whether to shrink or hold more capital.

Goldman Sachs Group Inc (GS.N) needs to take at least 16 points from its score to avoid a higher surcharge and Bank of America Corp (BAC.N) needs to shave eight points. Citigroup Inc (C.N) is two points under a markup, but could seek a wider margin because higher fourth-quarter stock prices are poised to add to all scores.

Backing away from certain short-term lending instruments, particularly swaps and other derivatives, is one of the easiest temporary ways to reduce scores, which are compiled from dozens of measurements and calculations.

Borrowers in the $3.2 trillion-a-day FX swap market are nervously looking toward year-end and having to decide between paying up or exiting positions.

The Federal Reserve has been stabilizing the repo market since mid-September when rates spiked to as much as 10% from about 2%.

Updated: 12-17-2019

Regulators Find Shortcomings In Resolution Plans At Six Large U.S. Banks

The banks must address the shortcomings by the end of March.

Regulators on Tuesday said they had found “shortcomings” in the resolution plans at six of the largest U.S. banks, while none of the eight major banks they examined had more serious “deficiencies.”

The Federal Reserve and Federal Deposit Insurance Corp. said the firms, including Bank of America Corp. , Citigroup Inc. and Wells Fargo & Co. had shortcomings related to their ability to reliably produce data needed to execute orderly wind-downs, also known as living wills, “in stressed conditions.”

The six banks, which also include Bank of New York Mellon Corp. , Morgan Stanley and State Street Corp. , must address the shortcomings by the end of March. They next submit living wills in 2021.

Tuesday’s moves, the regulatory equivalent of a slap on the wrist, are less severe than the finding of a “deficiency,” which could lead to more stringent capital and liquidity requirements for the firms.

The agencies didn’t find shortcomings in the plans from Goldman Sachs Group Inc. and JPMorgan Chase & Co.

Fed officials have grown increasingly confident that big U.S. banks are safer than they were in 2008, when the financial crisis exposed significant weaknesses in their risk management.

Tuesday’s findings are a turnabout from just three years ago, when the Fed ordered five big U.S. banks to make significant revisions to their plans, citing deficiencies.

“The largest banks have been making steady progress, and the regulators are in greater agreement on what progress is than in prior rounds,” said Karen Petrou, managing partner of Federal Financial Analytics, a regulatory advisory firm.

Wells Fargo said it was pleased the Fed found no deficiencies with its plan.

A Bank of New York spokeswoman said the lender “will work diligently to address the specific areas of feedback identified by the regulators in the required time frame.”

Spokesmen for Bank of America, Citi and JPMorgan declined to comment. The other banks didn’t immediately respond to requests for comment.

Kevin Fromer, president and chief executive of the Financial Services Forum, which represents the largest U.S. lenders, said the results show the firms “are strong, resilient and resolvable.”

Under the 2010 Dodd-Frank law, big banks must file plans showing they have a credible strategy to go through bankruptcy without causing a broader economic panic, one of many provisions in the law designed to prevent a repeat of financial-crisis bailouts.

Updated: 2-6-2020

Risky Corporate Debt To Take Center Stage In 2020 Stress Tests

The Federal Reserve will test the strength of the largest U.S. banks by subjecting them to a hypothetical recession.

The Federal Reserve will test the strength of the largest U.S. banks by subjecting them to a hypothetical recession in which credit markets seize up and private-equity investments take a hit.

The annual stress tests, in which 34 large banks must show how they would survive dramatic market and economic shocks, will feature a situation in which a severe global recession leads to “widespread defaults” on corporate loans, the Fed said Thursday.

In the worst-case scenario, which the Fed terms “severely adverse,” a broad selloff in corporate bonds and leveraged loans hits an array of risky credit instruments and private-equity investments, sending shocks through a variety of markets. The biggest banks in America—a group that includes JPMorgan Chase & Co. and Goldman Sachs Group Inc.—must pass the tests to return money to shareholders.

Leveraged loans are typically extended by banks to low-rated corporate borrowers. Many get packaged into structured products called collateralized loan obligations. Both have been among the hottest investments in recent years, raising concerns about how they would fare in a recession.

“This year’s stress test will help us evaluate how large banks perform during a severe recession, and give us increased information on how leveraged loans and collateralized loan obligations may respond to a recession,” said Randal K. Quarles, the Fed’s vice chairman for supervision.

The stress tests reflect the brisk growth in corporate debt in recent years. U.S. nonfinancial corporate debt has risen to nearly 47% of gross domestic product, a record high, according to the Fed and the Commerce Department.

The other pieces of the severely adverse scenario remained largely the same as last year, including a rise in the unemployment rate to 10%. It was at 3.5% in December, down from 3.9% a year earlier. The scenario also assumes a drop in real gross domestic product and falling inflation, as well as plunging stock prices and home values.

Updated: 4-4-2020

Fed Unlikely To Order Big U.S. Banks To Suspend Dividends

U.S. central bank isn’t seen following European counterparts in pressuring banks to halt dividends.

U.S. banks will likely be allowed to keep paying dividends to shareholders, according to people familiar with the matter, even as the coronavirus pandemic threatens to create a mountain of bad loans that could eventually weaken the lenders.

Some former U.S. regulators have said the Federal Reserve should order the largest banks to suspend payouts to preserve capital at a time of soaring unemployment and business disruption that may eclipse the 2008 financial crisis.

“If things work out well, banks can distribute income later on,” said Janet Yellen, a former Fed chairwoman. “If not, they’ll have a buffer that will be needed to support the credit needs of the economy.”

The European Central Bank and the Bank of England over the past week pressured banks to stop using their capital to make dividend payments to shareholders, raising questions about whether the Fed would follow suit in the U.S.

But Fed officials are unlikely to do so, at least in the short term. They see key differences in how lenders distribute capital on the two continents, and they plan to conduct a more deliberate analysis of the U.S. banking system’s health, the people said.

Cleveland Fed President Loretta Mester said she prefers to await the results of the next set of the banks’ “stress tests” in June before deciding whether to limit dividend payments. The tests are used to assess banks’ ability to continue lending in a crisis.

Updated: 6-25-2020

Fed Stress Test Finds U.S. Banks Not Healthy Enough To Withstand A Prolonged Economic Downturn

In its annual stress test, the Fed said the nation’s biggest banks are healthy but could suffer 2008-style losses if the economy languishes.

The Federal Reserve on Thursday said a prolonged economic downturn could saddle the nation’s biggest banks with up to $700 billion in losses on soured loans and ordered them to cap dividends and suspend share buybacks to conserve funds.

In a worst-case scenario, where unemployment remains high and the economy doesn’t bounce back for a few quarters, the 33 largest U.S. banks would suffer heavy loan losses that would erode the capital buffers meant to keep them on stable financial footing, the Fed said when it announced the results of its annual stress tests.

Designed to gauge the health of the nation’s banking system, the stress tests were expanded this year to study the effect of the downturn brought on by the coronavirus pandemic. The Fed said U.S. banks are strong enough to withstand the crisis and restricted dividend payouts and buybacks to make sure they stay that way.

Banks, which will announce their dividend plans for next quarter as soon as Monday, won’t be able to make payouts that are greater than their average quarterly profit from the four most recent quarters.

The Fed also barred them from buying back shares in the third quarter. Most of the largest banks had previously agreed to halt buybacks during the second quarter. Buybacks are the main way U.S. banks return capital to shareholders.

In a sign of the uncertainty facing the industry, the Fed required banks to resubmit updated capital plans later this year to reflect current stresses.

The central bank didn’t break out the results of the coronavirus analyses for individual banks. However, among the six largest, only Wells Fargo & Co. had a dividend payout that would breach the new threshold set by the Fed, according to Wolfe Research forecasts. The bank’s dividend in the third quarter would be 150% of its average expected profits over the past four quarters. A Wells Fargo spokesman declined to comment on the stress test results.

The Fed said limiting shareholder payouts would help keep banks healthy during the recession. Its analysis of the current pandemic found that if the economy takes a long time to recover, banks could experience losses similar to the financial crisis of 2008.

Banks could suffer losses on consumer debt such as auto loans and mortgages, as well as corporate debt and commercial real estate. Most of the firms would remain well capitalized, but some would approach their minimum capital levels.

Randal Quarles, the Fed’s point man on financial regulation, said the central bank could take additional steps to restrict buybacks or dividends “if the circumstances warrant.”

The Fed’s decision to allow banks to keep paying dividends during the crisis drew a sharp dissent from Lael Brainard, the Fed’s lone holdover from the Democratic Obama administration. Allowing banks to “deplete capital buffers,” she said, could force them to tighten credit in a protracted downturn.

“This is a time for large banks to preserve capital, so they can be a source of strength in a robust recovery,” she said in a statement. “This policy fails to learn a key lesson of the financial crisis, and I cannot support it.”

Former Fed officials and Democratic lawmakers have urged the central bank to prohibit both buybacks and dividends to ensure the firms could continue to lend if the economic fallout from the pandemic worsens.

Daniel Tarullo, who oversaw bank regulation at the Fed from 2009 until 2017, said Thursday’s moves “don’t really amount to much” and reflect a “substantial erosion” in the value of the annual tests. The Fed ought to have taken the time to recalibrate this year’s tests to reflect the actual coronavirus shock, rather than adding analysis that “apparently was not good enough to release on a bank-by-bank basis to the public,” but is nonetheless being used to inform bank capital policies during the third quarter.

The Fed annually releases a scenario for an economic catastrophe and then looks at banks’ ability to withstand it.

The results, which were broken out by individual banks and released Thursday, were largely as expected. But this year’s scenario was quickly overshadowed by the pandemic, whose economic effects were far worse.

After coronavirus ground the U.S. economy to a halt in March, the biggest U.S. banks set aside billions of dollars to cover a wave of expected loan defaults. In the months since, a period that saw unemployment surge to a post-World War II high, Americans skipped more than 100 million debt payments.

A gradual reopening of stores, restaurants and factories in recent weeks has given the economy a much-needed boost. But a recent surge in coronavirus cases in big states like Arizona, Texas and Florida has clouded the outlook.

Reflecting the uncertainty about how the economy will fare in the year to come, the Fed’s analysis looked at three extreme scenarios to gauge their effect on banks. The first was a “V-shaped” recovery, in which the economy bounces bank rapidly from a severe downturn. That would result in nearly $560 billion in loan losses across the nine-quarter period that the Fed studied.

A more prolonged downturn that led to a “U-shaped” recovery would cause $700 billion in loan losses. A “W-shaped” recovery in which the economy bounces back quickly but then takes another dip, would result in $680 billion in loan losses.

The analysis excluded capital distributions that were already planned and didn’t take into account government efforts to support the economy, such as expanded unemployment benefits and the Paycheck Protection Program.

Updated: 7-12-2021

China Just Cut Reserve Requirements For Its Banks. Why One Economist Is Worried

Trouble At China’s Banks?

The Chinese government has unexpectedly announced a broad-based RRR [reserve requirement rate] cut to be effective July 15. This isn’t the targeted cut mentioned in an important government meeting, and it sends a bad signal. So why does China need this cut? What’s wrong with the economy?

My own view is that the main intention of this cut is to help banks with their capital and liquidity requirements. From the Q&A written by the People’s Bank of China, we understand that this RRR cut aims to increase financial institutions’ capital and liquidity, and lower their cost of doing lending business.

This gives me a sense of unease. Are banks under stress? If this is the case, it implies there could be more bad loans. These bad loans could stem from the recent deleveraging reform. Banks haven’t been able to lend to real estate developers as easily as before and have shrunk their mortgage business. Fintechs, which banks also lend to, have also been subject to deleveraging reform.

After this RRR cut, banks should have more breathing room on capital and liquidity. But what’s next for the PBoC and banks? Banks cannot change the lending framework for real estate developers. But they could step into microlending left by fintechs, though this is a risky business. This means banks will continue to suffer from the same issues. And while they have some breathing room for now, this may only last for another quarter or so given that the release of liquidity is quite small compared to loans outstanding.

China may need another RRR cut in the fourth quarter.

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Monty H. & Carolyn A.

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