Federal Reserve Governor Tarullo Previews Proposal for Multiple Revisions to Capital Plans and Stress Tests That Will Increase Effective Capital Requirements for G-SIBs and May Reduce Effective Capital Requirements for Other CCAR Banking Organizations

In a speech earlier today at the Yale University School of Management Leaders Forum, Federal Reserve Board Governor Daniel Tarullo previewed several impactful proposals to amend the Federal Reserve’s CCAR stress test rules and procedures and its risk-based capital rules as applicable to bank holding companies with $50 billion or more in total consolidated assets (“CCAR BHCs”).1 The proposals, if implemented, would require CCAR BHCs to increase their regulatory capital levels—in some cases, and particularly for G-SIBs, substantially—if they are to avoid limitations on capital distributions and discretionary management compensation. This change would be made, in the first instance, by replacing the capital rules’ existing 2.5 percent capital conservation buffer with a substantially larger (at least for many CCAR BHCs) “stress capital buffer.” Additionally, the proposals would appear to require G-SIBs under supervisory stress tests in all scenarios, including the severely adverse scenario, to have poststress capital ratios that meet minimum capital requirements plus the applicable G-SIB surcharge, not just minimum capital requirements as under current rules. Implementation of the proposals would require amendments both to the Federal Reserve’s risk-based capital rules2 and to its capital plan3 and DFAST rules.4

Key aspects of the proposals outlined by Governor Tarullo include the following:

  • Replacing the existing capital conservation buffer with a new “stress capital buffer” requirement. For all CCAR BHCs, the capital rules’ 2.5 percent capital conservation buffer (“CCB”) would be replaced with a “stress capital buffer” (“SCB”). In contrast to the current uniform, static CCB requirement, the SCB would be risk-sensitive and would vary across CCAR BHCs. More specifically, each CCAR BHC’s SCB would be recalculated annually as part of the Federal Reserve’s CCAR process and would equal the CCAR BHC’s starting common equity tier one (“CET1”) capital ratio at the beginning of the planning horizon minus the CCAR BHC’s lowest CET1 ratio during the planning horizon based upon the Federal Reserve’s (and not the CCAR BHC’s) supervisory stress test under the severely adverse scenario—essentially a measure of the CCAR BHC’s decline in CET1 applying those standards. The minimum SCB would be 2.5 percent.
  • The SCB would be calculated before the inclusion of the CCAR BHC’s planned capital distributions, as opposed to after giving effect to those distributions. This is a change from existing CCAR requirements that would alleviate some of the impact of the SCB as a replacement for the CCB.
  • For G-SIBs, capital distribution and compensation restrictions would apply if the G-SIB’s CET1 ratio is below the sum of (i) 4.5 percent (the minimum); (ii) its SCB; and (iii) its G-SIB surcharge. For other CCAR BHCs, the sum would be limited to the first two elements. Governor Tarullo did not address whether the mechanics of the existing scheme, where the aggregate buffers are divided into four quartiles with limitations on capital distributions and discretionary compensation payments becoming progressively more severe, would continue to apply unadjusted.
  • Incorporating the G-SIB surcharge as a post-stress minimum capital requirement. Governor Tarullo did not clearly address whether the capital plan rule’s existing standard for a non-objection to capital distributions on quantitative grounds—namely, that, in order to receive a non-objection to its capital plan and be permitted to pay dividends and repurchase shares, a CCAR BHC must under all scenarios (including the severely adverse scenario) meet minimum capital requirements—would continue unchanged or whether, instead, the quantitative requirement for a non-obligation would be changed to require that the CCAR BHC must meet minimum capital requirements plus potentially the SCB and, for G-SIBs, plus the applicable G-SIB surcharge. Although not entirely clear, due to various references throughout Governor Tarullo’s remarks regarding the rationale for the “effective incorporation” of the G-SIB surcharge as a “post-stress capital expectation,” without using the same phrase for the SCB, we believe his intent is that the SCB would not be added to minimum requirements but the G-SIB surcharge would be added. 
  • Revising the treatment of planned dividends and share repurchases. In the existing CCAR process, the Federal Reserve assumes that all planned dividends and share repurchases would proceed during the two-year planning horizon, regardless of how much stress the CCAR BHC is under. Governor Tarullo stated that, under the SCB approach, the Federal Reserve would assume a CCAR BHC will maintain its dividends for one year while reducing its repurchases. CCAR BHCs have long argued that the assumption of no change to dividends and share repurchases at a time of stress is unrealistic and counter to sound capital management. Governor Tarullo’s description of the proposals makes some accommodation to that view. 
  • Modifying balance sheet and risk-weighted asset assumptions. The current models used in the Federal Reserve’s supervisory stress tests have operated to project an increase in the balance sheets of the CCAR BHCs during the severely adverse scenario, with various impacts on different portfolios. Governor Tarullo indicated that the Federal Reserve is considering replacing this feature with a simple assumption that balance sheets and risk-weighted assets remain constant over the severely adverse scenario horizon. This assumption would reduce riskweighted assets and total assets for most CCAR BHCs’ stress test calculations and would be particularly helpful for CCAR BHCs for which the leverage ratio is the binding constraint. 
  • Transparency. Governor Tarullo outlined a number of areas where the Federal Reserve has attempted to enhance CCAR transparency in recent years, and noted today that “[w]e are considering further steps, such as disclosing descriptions of changes well in advance of the stress test, and phasing in the most material model changes over two years, so as to smooth somewhat the effects of the changes on projected losses or revenues.” However, he emphatically rejected the industry’s most important concern in this area—the “black box” nature of the supervisory models, stating:

[L]et me now say that we do not intend to publish the full computer code in the supervisory model that is used to project revenues and losses. Full disclosure would permit firms to game the system—that is, to optimize portfolio characteristics based on the parameters of the model and take risks in areas not well-captured by the stress test just to minimize the estimated stress losses. In part for this reason, full disclosure could promote a “model monoculture” in which both supervisors and firms use the same models to evaluate risks. 

  • Eliminating the qualitative CCAR exercise for smaller firms. The Federal Reserve’s CCAR exercise involves both a quantitative and qualitative review of capital plans submitted by CCAR BHCs. A CCAR BHC must pass both reviews in order to receive a non-objection to dividend payments and share repurchases proposed in its capital plan. There has been substantial debate as to whether the benefits of a qualitative review for all CCAR BHCs outweigh the challenges and supervisory cost. Shortly after Governor Tarullo’s remarks this afternoon, the Federal Reserve released for public comment a proposed rulemaking under which CCAR BHCs with less than $250 billion in assets that do not have significant international or non-bank activity would no longer be included in the annual CCAR qualitative review. Under the proposal, all CCAR BHCs will continue to be subject to CCAR’s quantitative requirements.5 The proposed rulemaking also contains other amendments to the capital plan and DFAST rules, including a reduction in the amount of capital distributions a CCAR BHC can make outside a capital plan without prior Federal Reserve approval from 1 percent of Tier 1 capital to 0.25 percent of Tier 1 capital.

Governor Tarullo noted that, with respect to the Federal Reserve’s current estimates of the impact of the various changes he outlined, (i) for the eight U.S. G-SIBs, integration of the G-SIB surcharge with the post-stress requirements would be “somewhat less than half offset by the simplifying changes in the prefunding of capital distributions and the balance sheet assumptions,” although he predicted that the impact will “likely be greater for firms with larger G-SIB surcharges,” and (ii) for other CCAR BHCs, for which there are no capital surcharges, the simplifying assumptions he outlined will result in “some reduction of post-stress capital requirements.” He further noted that although the aggregate impact of these changes for CCAR BHCs as a whole should be “a modest increase in the total amount of required capital,” this increase will be “totally due to the impact on the eight” U.S. G-SIBs, whose increased capital requirements will “more than offset the reductions for the other firms.”

Governor Tarullo said these proposals are the result of an extensive review of statutory stress test and CCAR programs that began in 2015. He noted that although certain of the proposals could only be implemented through rulemakings, including the usual public notice-and-comment process, others may, in his view, be implemented through non-regulatory changes. Governor Tarullo further stated that the Federal Reserve does not contemplate proposing regulations to implement the proposals until early next year and that any changes would not apply to the capital plans or DFAST stress tests due in April 2017 and covering the nine-quarter planning cycle commencing on January 1, 2017.