Fed To Further Overhaul Stress-Testing Regime, Making It Easier For Banks To Pass (#Gotbitcoin?)
Regulator aims to make test scenarios more consistent from year to year, Quarles says. Fed To Further Overhaul Stress-Testing Regime, Making It Easier For Banks To Pass (#Gotbitcoin?)
The Federal Reserve plans to broaden its proposal to ease stress tests for the nation’s largest banks with changes that could reduce the chance they fail the annual assessments.
Fed Vice Chairman of Supervision Randal Quarles in a Friday speech said the agency was considering revisions that could make the test scenarios more consistent from year to year and give firms their results before they wrap up shareholder-return plans. Big banks must pass the Fed’s stress tests to be able to make shareholder payouts, although the timing of the test results means banks set those plans before knowing how they performed.
“It is prudent to review all our practices,” Mr. Quarles said in prepared remarks for a speech in Washington, “in light of changes in the industry that have been achieved.”
The changes under consideration “are not intended to alter materially the overall level of capital in the system,” he said. Some of the revisions are expected “in the not-too distant future,” he added.
Banks will likely welcome what Mr. Quarles outlined as a sweetening of an April proposal that was already set to ease the stress-testing burden.
“We believe this should permit mega banks to boost distribution levels while reducing the risk of an unexpected” stress-test result, Cowen & Co. analyst Jaret Seiberg said in a note to clients.
Mr. Quarles also recommended that financial institutions with less than $250 billion in assets, which include SunTrust Banks Inc. and Fifth Third Bancorp , should skip the 2019 tests as they are set to enter a two-year evaluation schedule under a different Fed proposal.
Each year, banks’ balance sheets must run through a hypothetical doomsday scenario presented by the Fed that measures whether banks could keep lending during a severe downturn. Some years present tougher challenges than others, and banks have complained it is hard to adjust capital levels to a moving target. The latest round in June was the toughest to date, and Goldman Sachs Group Inc. and Morgan Stanley almost failed.
Mr. Quarles said the Fed was considering addressing a key roadblock for banks in the stress tests: receiving results after making plans for the following year’s shareholder dividends and share buybacks. This puts them at risk of paying less to shareholders than they actually could, or failing the tests if they distribute too much, Mr. Quarles said.
“Firms have told us that they would be able to engage in more thoughtful capital planning” if they got the results before making payout plans, Mr. Quarles said. Such a change could effectively eliminate the possibility that a bank gets publicly shamed by failing the tests.
Mr. Quarles recommended eliminating a capital requirement known as the leverage ratio from the stress tests. That would be a significant change, as some banks have been tripped up by that part of the tests in years past. Mr. Quarles said the leverage ratio, which compares equity to total assets and doesn’t take into account the relative riskiness of different bank loans and investments, might not be consistent with the “risk-sensitive” stress tests.
The Fed official also proposed modifying capital buffers, which force banks to gradually build up capital when they edge close to the Fed’s minimum. Buffers require big banks to sock away additional capital during good times so they have more to fall back on during bad times.
Existing buffers are too tough “in our current world in which a healthy and profitable banking system is seeking to maintain its capital levels rather than continue to increase them,” Mr. Quarles said.
He also said stress tests should be more transparent, suggesting for instance that the Fed seek public input as it crafts doomsday scenarios. He acknowledged giving banks more information up front could create an opportunity for banks to game the tests. But after the speech, he said more disclosure about the test was akin to giving the banks a textbook to prepare for the tests, not the test questions.
Fed Considers New Tool For A Downturn
The countercyclical capital buffer would require banks to hold more capital should the economy show signs of overheating.
Federal Reserve officials are weighing whether to use a tool that could reduce the risk of a credit crunch in a downturn.
The tool is known as the countercyclical capital buffer. It allows the Fed to require banks to hold more loss-absorbing capital should the economy show signs of overheating, or to keep less of it during bad economic times. The buffer applies generally to banks with more than $250 billion in assets, including firms such as JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc.
The Fed’s board of governors so far hasn’t used the tool, approved in 2016. Its rule on the buffer says it should turn it up when economic risks are “meaningfully above normal” and reduced when they “abate or lessen.”
Now, some Fed officials are debating whether it is time to use the tool, which could provide banks with additional lending firepower in a subsequent downturn. It isn’t clear when they might make a decision.
“The idea of putting it in place so you can cut it, that’s something some other jurisdictions have done, and it’s worth considering,” Fed Chairman Jerome Powell said at a late July press conference.
Deciding whether to use the buffer is somewhat fraught, though. Banks are reluctant to hold even more capital than they do today as this could hamper their profitability. That is already under strain due to low interest rates.
Plus, it isn’t clear how markets would interpret such a move by the Fed, especially since this would be a first. Investors could find the buffer reassuring, believing the Fed is giving itself additional room to fight a downturn. Or they could be unsettled by it, fearing the Fed believed a slowdown is imminent.
Fed officials have been debating about whether to use the tool since last year. Now, they are raising another question: how it should be used.
Some officials have suggested turning it on without increasing capital levels—signaling the Fed is prepared to use the tool, even if not right away. Others think higher capital requirements should be applied now.
Either move would give the central bank the option of lowering the requirement during a downturn.
Fed Gov. Lael Brainard, an Obama appointee, favors turning on the buffer now and raising capital requirements for big banks. She dissented from a March Fed vote to leave the buffer dormant.
“Turning on the [buffer] would build an extra layer of resilience and signal restraint, helping to damp the rising vulnerability of the overall system,” she said in a May speech.
Others say capital levels are already high enough, and that the tool could be used instead as a release valve for bad times.
“We rely on through-the-cycle, always on, high capital and liquidity requirements,” Mr. Powell said. “I view the level of capital requirements and the level of capital in the system as being about right.”
Randal Quarles, the Fed’s vice chairman for bank supervision, at a July Fed conference in Boston said, “The overall risk to financial stability is swamped by the extremely low leverage in the financial sector. ”
Messrs. Quarles and Powell have cited the Bank of England’s approach as a possible model for the U.S. In the U.K., the countercyclical capital buffer is set at 1% of risk-weighted assets when risks are “neither subdued nor elevated,” allowing the central bank to dial it down if the economy is thrown a curveball.
Banks have argued the buffer shouldn’t be turned on now because they are already subject to regulations, including other capital requirements, that ensure they are prepared for bad times. One example is the Fed’s annual stress tests that banks must pass to prove they would continue lending in a recession.
At the same time, they have encouraged the Fed to reduce other capital requirements. The central bank would likely have to do that if it activated the countercyclical capital buffer while maintaining the same amount of capital in the banking system, as suggested by Messrs. Powell and Quarles.
The countercyclical capital buffer was created in 2010 by international regulators through the Basel Committee on Banking Supervision. It is being used in other parts of the world, including Sweden and Hong Kong.
Banks Struggled Last Year, But Now They Are Set For Big Profits
JPMorgan, Goldman Sachs and other big banks are expected to report large second-quarter gains this week.
The economic recovery is looking good for the biggest U.S. banks.
Major players such as JPMorgan Chase & Co. and Citigroup Inc. are expected this week to report second-quarter profit gains, a U-turn from a year ago when they were girding for a wave of Covid-19-related loan defaults.
At the same time, there are obstacles. For example, the trading businesses that thrived in the chaos of the pandemic are slowing down.
JPMorgan and Goldman Sachs Group Inc. report results Tuesday, followed by Citigroup, Bank of America Corp. and Wells Fargo & Co. on Wednesday. Morgan Stanley releases results on Thursday.
A year ago, banks were socking away billions of dollars to prepare for soured loans. But as the economic outlook has brightened, banks have started releasing reserves, boosting their earnings. Banks could report second-quarter per-share profits that are 40% higher than the same period a year ago, according to analysts at Keefe, Bruyette & Woods.
However, the trading boom that powered banks through the pandemic wasn’t repeated in the second quarter. Citigroup and JPMorgan executives have said trading revenues would be down 30% or more compared with a year ago. That could amount to losing about 10% of total revenue at each bank.
“We believe that this summer represents the acid test for whether normalized trading levels will be higher than pre-pandemic,” Goldman analysts wrote.
Loan demand has been tepid, and low interest rates have dampened the profits that banks can make when they do lend. The industry’s net-interest margin, a key measure of lending profitability, hit a historic low in the first quarter, and analysts expect roughly the same for the second quarter.
Rising interest rates and increased lending, particularly to consumers, would provide a double-barreled lift, but it is still unclear when either will happen. Autonomous Research is predicting 2021 net-interest income declines at the big banks, noting executives “have recently been moderating their expectations (without completely giving up hope).”
Banks have plenty of money to lend—more than enough, in fact. Many companies are still hoarding cash, and there is now $17 trillion in deposits at U.S. commercial banks, according to data from the Federal Reserve. That is up nearly 30% since the start of 2020, or $3.8 trillion, equal to the size of the whole pot in 2001.
The excess cash is dragging down margins because banks aren’t earning much on it. Barclays PLC analysts estimate average pretax profits would be 5% higher if that excess cash could be put to work at better interest rates.
The biggest banks shelled out money during the depths of the pandemic to waive customer fees and get employees set up to work from home. Now they are trying to reel expenses back in.
Bank of America Chief Financial Officer Paul Donofrio said on the first-quarter earnings call with analysts: “We’re sitting here in the middle of a pandemic with a lot of Covid expenses that have been a little bit more sticky than we had all hoped, but they’re going to come out. There’s no question about that.”
The KBW Nasdaq Bank Index has risen 27% in 2021, topping the S&P 500’s 16% increase. Where the bank-stock rally goes from here will depend partly on how much banks lift their dividends and buy back their shares. The Fed had limited shareholder returns during the pandemic, but removed restrictions at the end of June.
The six biggest banks collectively have already raised their per-share dividends 40% for the third quarter and some announced new buyback programs, but additional details may surface in earnings reports.
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