Bank Capital Requirements, Capital Plans and Stress Tests

SULLIVAN & CROMWELL LLP

April 19, 2018

Bank Capital Requirements, Capital Plans

and Stress Tests

Federal Reserve Proposes Substantial Changes to CCAR and Its

Capital Rules, Including New Stress Capital Buffer and Stress

Leverage Buffer Requirements and the Elimination of the CCAR

Quantitative Objection

SUMMARY

On April 10, 2018, the Federal Reserve issued a proposal

designed to create a single, integrated capital

requirement by combining the quantitative assessment of CCAR

with the buffer requirements of the

Federal Reserve’s regulatory capital rules for bank holding companies with $50 billion or more in total

consolidated assets and U.S. intermediate holding companies of foreign banking organizations

(collectively, “CCAR firms”).

Most significantly, for CCAR firms the proposal would:

 replace the current static 2.5 percent capital conservation buffer with a stress capital buffer

(“SCB”) requirement for standardized approach capital ratios, based on (i) the projected decrease

in a CCAR firm’s common equity tier 1 (“CET1”) capital ratio in the severely adverse scenario of

the Federal Reserve’s supervisory stress test, plus (ii) the ratio of the firm’s planned common

stock dividends to projected risk-weighted assets for the fourth through seventh quarters of the

planning horizon, subject to a floor of 2.5 percent; and

 eliminate the quantitative objection provisions of CCAR.

The Federal Reserve notes that the proposal would simplify its regulatory capital framework by reducing

the total number of capital requirements from 24 to 14, since firms would no longer need explicitly

manage to post-stress capital ratios based on CCAR stress tests.

Although the proposal would eliminate

the quantitative objection, the CCAR process and the Federal Reserve’s supervisory stress test for the

severely adverse scenario would continue to play a central role in establishing CCAR firms’ binding

capital constraints. Notably, however, the Federal Reserve would retain the CCAR qualitative

assessment for those CCAR firms to which it currently applies.

In addition to the SCB, the Federal

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Reserve proposed a new stress leverage buffer (“SLB”) requirement, based primarily on the projected

decrease in a CCAR firm’s tier 1 leverage ratio in the severely adverse scenario of the Federal Reserve’s

supervisory stress test. Under the proposal, if a CCAR firm’s tier 1 leverage ratio were not greater than

the 4 percent minimum plus the CCAR firm’s SLB requirement, the CCAR firm would be subject to

restrictions on capital distributions and discretionary bonus payments. In this way, the SLB requirement

would operate in a similar manner as the SCB requirement and the existing regulatory capital buffer

requirements.

The SCB and SLB requirements could constrain a CCAR firm’s ability to make capital distributions in two

ways.

 First, under the proposed revisions to the capital rules, and as is currently the case,

a CCAR firm

would be required to maintain capital ratios above the applicable minimum requirements plus the

applicable buffer requirements in order to avoid being subject to restrictions on capital

distributions and discretionary bonus payments; such restrictions become more stringent as a

CCAR firm’s capital levels approach the minimum requirements.

 Second, under the proposed revisions to the capital plan rule,

a CCAR firm would face

restrictions on its planned capital distributions if its own baseline scenario projections indicate that

it would not satisfy applicable buffer requirements; specifically, the capital distributions included in

a CCAR firm’s capital plan for any given quarter must be consistent with the projected capital

distribution limitations that would apply in that quarter. As is currently the case, a CCAR firm

would generally not be permitted to exceed the capital distributions reflected in its capital plan

either on a gross basis or net of capital issuances without prior approval of the Federal Reserve.

Beyond the revisions to integrate and simplify the capital and capital planning requirements, the Federal

Reserve also proposed modifications to the assumptions in its supervisory stress tests, which are

intended to better align the assumptions with CCAR firms’ expected behavior in periods of stress.

Specifically:

 The Federal Reserve would no longer assume that a CCAR firm makes all its planned capital

distributions (including common stock dividends, repurchases of common stock and redemptions

of other capital instruments) in all stress scenarios. The Federal Reserve would, however,

effectively continue to assume that CCAR firms pay planned common stock dividends in the

fourth through sevenths quarters of the planning horizon because those dividends would factor

into the calculation of the SCB and SLB. Common stock repurchases typically represent a larger

portion of CCAR firms’ planned capital distributions than common stock dividends, and the

revised framework could have a significant effect on the extent to which CCAR firms must precapitalize

planned

capital

distributions

account

the

CCAR

stress

tests.

 The Federal Reserve would assume that CCAR firms’ balance sheets remain constant, rather

than grow, under stress, which is designed to achieve the Federal Reserve’s macroprudential

objective of preventing CCAR firms from planning to “shrink to health” and restricting the

availability of credit in stress while also addressing criticism that the growth assumption was

unrealistic and overly distortive.

The proposal includes a number of other modifications to the capital rules and the capital plan rule, as

well as CCAR and DFAST, that reflect and implement the proposed integrated framework, including the

elimination of the 30 percent dividend payout ratio as a criterion for heighted scrutiny of a CCAR firm’s

capital plan. The proposal would become effective December 31, 2018, and a CCAR firm’s first SCB and

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Because the proposal relates only to the

capital requirements for CCAR firms, it would not affect the capital buffer requirements for bank holding

companies that are not CCAR firms or for insured depository institutions, including subsidiaries of CCAR

firms.

SLB requirements would become effective October 1, 2019.

Comments are due within 60 days of the publication of the proposal in the Federal Register.

DISCUSSION

 Creation of the SCB Requirement and Elimination of the CCAR Quantitative Objection.

The most significant element of the Federal Reserve’s proposal is the creation of the SCB

requirement, intended to make each CCAR firm’s capital requirements better tailored to its risk

profile and potential vulnerability to stress.

The SCB requirement would replace the current

static 2.5 percent component of the capital conservation buffer requirement for purposes of

standardized approach capital ratios. In order to avoid restrictions on capital distributions, CCAR

firms would be required to maintain risk-based capital ratios, including CET1 capital ratios, in

excess of the applicable minimum requirement, plus the CCAR firm’s SCB requirement, plus the

CCAR firm’s G-SIB surcharge (if applicable), plus the countercyclical capital buffer (if applicable).

This SCB-based requirement (the “Standardized Approach Capital Conservation Buffer

Requirement,” or “SA-CCB Requirement”) applies only to risk-based capital ratios calculated

using the standardized approach. CCAR firms subject to the advanced approaches would also be

required to comply with a separate non-SCB-based capital buffer requirement for risk-based

capital ratios calculated using the advanced approaches (the “Advanced Approaches Capital

Conservation Buffer Requirement,” or “AA-CCB Requirement”), which would continue to reflect

the static 2.5 percent capital conservation buffer and, thus, be less than or equal to the SA-CCB

Requirement.

 Calculation of the SCB Requirement. In effect, the SCB would require CCAR firms to precapitalize

stressed

losses

and

four

quarters

planned

common

stock

dividends

order

avoid

limitations on capital distributions and discretionary bonus payments under the buffer

requirements in the capital rules.

Specifically, the SCB requirement would be a start-totrough

measure

equal

a CCAR firm’s starting CET1 capital ratio, minus the CCAR firm’s

lowest projected CET1 capital ratio under the severely adverse scenario in the Federal

Reserve’s supervisory stress test, plus the sum of the ratios of the dollar amounts of the

CCAR firm’s planned common stock dividends to projected risk-weighted assets (“RWAs”) for

each of the fourth through seventh quarters of the planning horizon.

The SCB requirement

would be subject to a floor of 2.5 percent, in order to prevent the SCB from falling below the

existing static capital buffer requirement.

As is currently the case, only the standardized approach would be used to calculate riskbased

capital ratios in connection with CCAR, including those used to calculate a CCAR

firm’s SCB requirement. The Federal Reserve explains that the advanced approaches are

not used in connection with CCAR or the SCB requirement due to the “significant resources

required to implement the advanced approaches on a pro forma basis and due to the

complexity and opaqueness associated with introducing the advanced approaches in

supervisory stress test projections.”

The Federal Reserve also observes that “both the

supervisory stress test and the advanced approaches are calibrated to reflect tail-risks; thus,

it could be duplicative to require a firm to meet the requirements of the advanced approaches

on a post-stress basis.”

This observation about duplication between CCAR stress tests and the advanced

approaches is notable because it may provide some indication for how the Federal Reserve

will approach the interaction of CCAR and the standards recently released by the Basel

Committee to finalize the Basel III capital framework (commonly referred to as “Basel IV”).

At this time, it is unclear whether and, if so, how the standardized approaches in the Basel IV

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output floor but not the current U.S. standardized approach (i.e., operational risk and credit

valuation adjustment (“CVA”) risk) will be incorporated into the U.S. capital rules and CCAR.

Simply revising the U.S. standardized approach to incorporate requirements for operational

risk and CVA risk, without any adjustment to CCAR, would result in double-counting; in

CCAR, projections reflect, among other things, operational risk and CVA losses. Under the

Basel IV operational risk capital requirements, operational risk losses directly affect one of

the components—the Internal Loss Multiplier—used to calculate operational risk RWAs.

stressed operational risk loss could thus be recognized in capital twice: once through a

reduction in earnings (and, therefore, the numerator of capital ratios) and a second time

through increasing operational risk RWAs. Similar issues could arise in connection with CVA,

as the losses relating to changes in the credit quality of a counterparty are already captured

through CVA adjustments and reflected in the numerator. The Federal Reserve’s

observations suggest that the Federal Reserve is cognizant of potential double-counting of

risk elements in stress testing and may seek to avoid double-counting in CCAR if the U.S.

standardized approach incorporates operational risk and/or CVA risk in connection with the

U.S. implementation of Basel IV.

The Federal Reserve’s commentary on the reasons for not using the advanced approaches

in connection with CCAR also highlights important issues relating to the upcoming

implementation of the new accounting standard for the recognition of credit losses (the

current expected credit loss methodology or “CECL”), which will take effect in January 2020

for SEC reporting companies, including most CCAR firms. Under current U.S. GAAP, a

company reflects credit losses on financial assets measured on an amortized cost basis only

when the losses are probable or have been incurred, and generally considers only past

events and current conditions in making these determinations. CECL prospectively replaces

this approach with a forward-looking methodology that reflects the expected credit losses

over the lives of financial assets, starting when such assets are first acquired. Under CECL,

credit losses will be measured based on past events, current conditions and reasonable and

supportable forecasts that affect the collectability of financial assets. Compared to current

U.S. GAAP, CECL will result in earlier recognition of credit losses and, potentially, greater

volatility in allowances for credit losses.

Because of CECL’s incorporation of a forwardlooking

methodology and forecasts, as well as the recognition of losses over the lives of

financial assets, the interaction of CECL and CCAR raises similar issues as the use of the

advanced approaches in stress testing—specifically, issues relating to complexity,

opaqueness, duplication of risk elements and calibration of the stress tests. On April 13 and

17, 2018, the Federal Reserve, FDIC and OCC released a joint proposed rule that would

revise the agencies’ capital rules to phase in the day-one adverse effects on regulatory

capital resulting from the implementation of CECL and to revise their stress test rules so that

the effects of CECL are not reflected in stress test results until the 2020 stress test cycle.

remains to be seen how the Federal Reserve will address the interaction of CECL, CCAR

and the new stress buffer requirements.

 Elimination of CCAR Quantitative Objection; Retention of Qualitative Objection. The

Federal Reserve states that a central purpose of the proposal is to “simplify the capital

regime applicable to firms subject to the capital plan rule.”

Accordingly, the proposal would

end the CCAR quantitative objection in order to “eliminat[e] the need for firms to manage to

both potential sources of limitations on capital distributions,”

i.e., to the post-stress

requirements in the capital plan rule and the capital buffer requirements in the capital rules.

The capital plan rule and CCAR would still operate to place certain restrictions on a CCAR

firm’s ability to make capital distributions, but those restrictions would be integrated with the

requirements of the capital rules.

Notably, however, the proposal would retain the qualitative objection for CCAR firms subject

to the Large Institution Supervision Coordination Committee framework and for “large and

complex” firms (i.e., those that are U.S. global systemically important bank holding

companies, or that have $250 billion or more of total consolidated assets or $75 billion or

more of total nonbank assets). The Federal Reserve does, however, specifically request

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SULLIVAN & CROMWELL LLP

comment on the advantages or disadvantages of removing or adjusting the qualitative

objection for those CCAR firms.

and former Governor Tarullo

In light of recent comments by Vice Chairman Quarles

about the future of the qualitative objection, as well as the

Federal Reserve’s recent proposal to implement a new rating system for large financial

institutions designed to align with the supervisory program for those institutions,

the

request for comment suggests that the Federal Reserve may be considering whether to

eliminate the qualitative objection for additional—or potentially all—CCAR firms.

 Advanced Approaches Capital Conservation Buffer Requirement. In addition to the SACCB

Requirement, which would apply to all CCAR firms, the AA-CCB Requirement would

apply to the advanced approaches capital ratios of CCAR firms subject to the capital rules’

advanced approaches.

The AA-CCB Requirement would be equal to 2.5 percent, plus the

G-SIB surcharge (if applicable), plus the countercyclical capital buffer (if applicable).

Thus,

the AA-CCB Requirement essentially retains the existing capital buffer requirement with

respect to advanced approaches capital ratios. Because the SCB is subject to a floor of 2.5

percent, the SA-CCB Requirement for an advanced approaches CCAR firm would always be

greater than or equal to its AA-CCB Requirement.

The proposal discusses the importance of stress testing in the Federal Reserve’s supervisory

program for large financial institutions.

By integrating the Federal Reserve’s capital

planning and stress testing requirements with the standardized approach in a manner that

would generally result in higher capital buffer requirements for the standardized approach

than for the advanced approaches, the proposal has the potential to significantly increase the

relevance and relative stringency of the standardized approach. In this regard, it is notable

that Basel IV expressly provides that a jurisdiction will be compliant with the Basel framework

even if it does not implement some or all of the model-based approaches. If adopted, the

proposal would likely contribute to further uncertainty as to the future role and relevance of

the advanced approaches in the U.S. capital rules.

 Creation of the SLB Requirement. In addition to the SCB requirement, the proposal would also

introduce the SLB requirement (together with the SCB requirement, the “stress buffer

requirements”).

The proposal would require a CCAR firm to maintain its tier 1 leverage ratio

above the 4 percent minimum, plus the CCAR firm’s SLB requirement in order to avoid

restrictions on capital distributions and discretionary bonus payments. According to the Federal

Reserve, this new requirement would “help to maintain the current complementary relationship

between the risk-based and leverage capital requirements in normal and stressful conditions” and

to “continue the current practice of evaluating a CCAR firm’s vulnerability to declines in its

leverage ratio under stressful conditions.”

The method for calculating the SLB requirement would be analogous to that for calculating the

SCB. Specifically, a CCAR firm’s SLB requirement would equal its starting tier 1 leverage ratio,

minus the CCAR firm’s lowest projected tier 1 leverage ratio under the severely adverse scenario

in the supervisory stress test, plus the sum of the ratios of the dollar amounts of the CCAR firm’s

planned common stock dividends to projected leverage ratio denominator for each of the fourth

through seventh quarters of the planning horizon.

The SLB requirement would not have a floor,

reflecting that there is not currently a generally applicable leverage buffer under the capital rules.

Notably, the stress buffer concept would not extend to the supplementary leverage ratio because

“[a] single stress leverage ratio, applicable to all firms, would provide a sufficient backstop and

avoid adding additional complexity.”

 Limits on Capital Distributions Under the Proposed Revisions to the Capital Rules and

Capital Plan Rule. Under the proposal, as currently is the case, both the capital rules and the

capital plan rule would place restrictions on the ability of CCAR firms to make certain capital

distributions. The capital rules place graduated constraints on a banking organization’s (including

a CCAR firm’s) ability to make capital distributions or discretionary bonus payments based on the

amount of any shortfall in satisfying applicable minimum capital requirements and applicable

buffer requirements.

The capital plan rule would generally not permit a CCAR firm to make

capital distributions in excess of those included in its capital plan, on a gross basis or net of

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April 19, 2018

SULLIVAN & CROMWELL LLP

capital issuances without the prior approval of the Federal Reserve, and a CCAR firm would be

required to reduce its planned capital distributions if its own baseline scenario projections indicate

that the CCAR firm’s distributions would not be consistent with applicable capital distribution

limitations throughout the planning horizon.

 Restrictions on Capital Distributions and Discretionary Bonus Payments Under the

Capital Rules. With respect to each of the three buffer requirements addressed in the

proposal (i.e., the SA-CCB Requirement, the AA-CCB Requirement (if applicable), and the

SLB requirement), a CCAR firm would be subject to restrictions on its ability to make capital

distributions and discretionary bonus payments if a capital ratio falls below the applicable

minimum requirement plus any buffer requirement. The stringency of the limitations would

become more severe as a ratio approaches the regulatory minimum.

A CCAR firm would be subject to the most stringent distribution limitation, if any, under any of

the applicable buffer requirements, including these three requirements and, as applicable, the

enhanced supplementary leverage ratio (“eSLR”) and the TLAC buffer requirements.

 Restrictions on Capital Distributions Under the Capital Plan Rule. As is currently the

case, under the proposal, a CCAR firm would be required to submit an annual capital plan

detailing its planned capital actions over a nine-quarter planning horizon. CCAR firms would

generally not be permitted to exceed the capital distributions included in their capital plans,

either on a gross basis or net of capital issuances without the prior approval of the Federal

Reserve.

The proposal would retain the de minimis exception for capital distributions above

the amount reflected in a CCAR firm’s capital plan equal to 0.25 percent of tier 1 capital.

Unlike the capital rules, the capital plan rule would not directly impose limits on discretionary

bonus payments, and a CCAR firm would not be required to include discretionary bonus

payments in its capital plan.

Although the proposal would eliminate the quantitative objection, it would introduce a new

requirement that all planned capital distributions for any given quarter of the planning horizon

be consistent with the capital distribution limitations in effect for that quarter under the capital

rules and, if applicable, the TLAC rule. A CCAR firm’s compliance with the anticipated capital

distribution limitations for a quarter is based on the CCAR firm’s projected ratios for that

quarter under the CCAR firm’s own baseline scenario.

Given that a CCAR firm would not

know its stress buffer requirements beginning with the fourth quarter of the planning horizon

at the time it submits its capital plan, the Federal Reserve proposed codifying the CCAR

“mulligan” in the capital plan rule. Like the existing “mulligan” that has been included in the

CCAR instructions, the proposal would provide CCAR firms with a two-business-day period to

reduce their planned capital distributions after they receive initial notice of their stress buffer

requirements.

 Continued Significance of the Supervisory Severely Adverse Scenario in Determining

Effective Capital Requirements. Under the proposal, a CCAR firm’s stress buffer

requirements would be determined by the CCAR firm’s projected financial performance in the

supervisory severely adverse scenario of the Federal Reserve’s supervisory stress test.

Potentially in light of the continued—and perhaps enhanced—significance of this scenario,

the Federal Reserve has specifically requested comment on the advantages and

disadvantages of publishing for notice and comment the severely adverse scenario used in

calculating a CCAR firm’s stress buffer requirements.

 Additional Scrutiny and Relevance of the BHC Baseline Scenario. The proposal would

introduce a new requirement that a CCAR firm must reduce its planned capital distributions if

its own projections for its own baseline scenario (commonly referred to as the “BHC baseline

scenario”) indicate that its capital distributions would not be consistent with applicable buffer

distribution limitations in each quarter of the planning horizon. The Federal Reserve

recognizes that “[b]asing capital distribution restrictions on a firm’s projections in its BHC

baseline scenario may create incentives for a firm to be overly optimistic about its baseline

projections in order to increase the amount of permissible capital distributions.”

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Accordingly, to provide CCAR firms with incentives to “project realistic baseline earnings,” the

Federal Reserve notes that “[a] pattern of materially underperforming baseline projections for

earnings, capital levels, or capital ratios may be indicative of weaknesses in the firm’s capital

planning and result in heightened scrutiny in the qualitative assessment,” and that CCAR

firms may be required to resubmit if their capital plans in certain circumstances if they

materially underperform their projections.

The relevance of the BHC baseline scenario would increase under the proposal. Under the

current CCAR framework, in practice, the BHC baseline scenario does not determine whether

a CCAR firm receives a quantitative objection and faces limits on capital distributions under

the capital plan rule; under the proposal, the BHC baseline scenario projections directly affect

a CCAR firm’s distribution capacity. In addition, the Federal Reserve stated that it “intends to

monitor and evaluate a firm’s quarterly performance relative to its baseline projections to help

ensure that the firm adopts processes that a realistically project performance and capital

levels.”

The new focus on the BHC baseline scenario is notable because the Federal

Reserve’s supervisory guidance—such as SR Letters 15-18 and 15-19—had previously

centered on CCAR firms’ own stress scenarios.

 Reduced Significance of the Supervisory Baseline and Adverse Scenarios in

Determining Effective Capital Requirements. The Federal Reserve would calculate both

stress buffer requirements using the severely adverse scenario in its supervisory stress test.

Under the current CCAR framework, it is highly unlikely that a CCAR firm would pass the

quantitative assessment in the supervisory severely adverse scenario but fail in either the

supervisory adverse or baseline scenarios. Because the proposal would practically eliminate

the relevance of the supervisory adverse and baseline scenarios in CCAR, proponents of

simplifying the supervisory stress testing framework by reducing the number of scenarios

may cite the proposal as further reason to eliminate the adverse scenario.

 Timing of Annual Calculation of and Updates to the Stress Buffer Requirements. The

Federal Reserve would calculate a CCAR firm’s stress buffer requirements for the fourth quarter

of one year through the third quarter of the next year in connection with the annual CCAR

process, which would continue to be concentrated in the second quarter of the year. CCAR firms

would continue to be required to submit their capital plans by April 5, and the Federal Reserve

would complete its assessment of the plans, which includes the application of the supervisory

stress tests, by June 30. Under the proposal, the Federal Reserve would provide each CCAR

firm with initial notice of its stress buffer requirements by June 30.

The proposal would provide

that adjustments may be made to the stress buffer requirements in certain circumstances. The

Federal Reserve would provide a CCAR firm with its final stress buffer requirements by August

31.

These final requirements would take effect on October 1, and would apply to the CCAR firm

through September 30 of the following year.

The Federal Reserve would recalculate a CCAR

firm’s stress buffer requirements, potentially using an updated severely adverse scenario, if a

CCAR firm resubmitted its capital plan.

 Process and Requirements for Adjustments to Capital Plans and Reconsideration of

Stress Buffer Requirements. Notably, a CCAR firm would not know its stress buffer

requirements for the fourth through ninth quarters of the planning horizon, and therefore the

capital requirements and capital distribution limits for those quarters, at the time it submits its

capital plan. A CCAR firm would not receive notice of its updated stress buffer requirements until

after the Federal Reserve has completed its assessment of the capital plans and provided initial

notice, which would occur by June 30. To account for this, the Federal Reserve has proposed to

codify the “mulligan” in the capital plan rule. Specifically, the proposal would incorporate into the

capital plan rule itself a process by which CCAR firms must revise their planned capital

distributions if the capital distributions included in their capital plans are not consistent with the

capital distribution limitations that are projected to apply throughout the planning horizon. The

proposal also includes a process by which CCAR firms may request reconsideration of the their

stress buffer requirements.

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 Requirements and Process for Adjusting Planned Capital Distributions in a Capital

Plan. Under the proposal, within two business days of receipt of initial notice of stress buffer

requirements, a CCAR firm would be required to assess whether its planned capital

distributions are consistent with the effective capital distribution limitations that would apply

on a pro forma basis under the CCAR firm’s projections for the BHC baseline scenario.

doing so, a CCAR firm must generally assume that the countercyclical capital buffer and the

G-SIB surcharge, in each case, if applicable, would remain constant over the period, unless it

knew that a change will take effect (for example, if it knew a higher G-SIB surcharge would

apply beginning in the fifth quarter of the planning horizon).

If the CCAR firm’s planned

capital distributions would not be consistent with the applicable capital distribution limitation

limitations under the buffer requirements, it would be required to reduce the capital

distributions in its capital plan to be consistent with the limitations, and provide notice of these

reductions to the Federal Reserve.

The Federal Reserve would then recalculate the stress

buffer requirements based on the adjusted planned capital actions and would provide the

final stress buffer requirements, based on the adjusted planned capital actions, and

confirmation of the CCAR firm’s final planned capital distributions for the coming year by

August 31. As noted above, the final stress buffer requirements would become effective on

October 1.

The August 31 deadline for CCAR firms to be informed of their final stress buffer

requirements appears to be intended to accommodate the timeline for the reconsideration

process. If a CCAR firm adjusts its planned capital distributions but does not request

reconsideration of its stress buffer requirements, it is likely that the Federal Reserve would be

able to inform the CCAR firm of its final stress capital buffer well in advance of August 31.

The proposal does not address whether the Federal Reserve expects to inform CCAR firms

of their final stress buffer requirements at different times depending on whether they only

adjust their planned capital actions or seek reconsideration of the requirements.

Even if a CCAR firm’s planned capital distributions are consistent with the requirements and it

is therefore not required to reduce its planned capital distributions after receiving the initial

notice, it will be permitted to do so.

It may choose to modify its planned capital distributions

to, for instance, lower the stress buffer requirements that will apply to it over the coming year.

Although not directly discussed, the proposal appears to indicate that the Federal Reserve

would revise the approach and sequencing for disclosing DFAST and CCAR results in

connection with the introduction of stressed buffer requirements. In particular, the proposal

indicates that the Federal Reserve would concurrently notify CCAR firms and publicly

disclose initial stress buffer requirements, after which CCAR firms would have two business

days to revise their planned capital distributions.

This approach would differ from the

current sequencing, in which CCAR firms are informed of their results in the CCAR stress

tests, and have the opportunity to revise their planned capital distributions, before the Federal

Reserve publicly announces CCAR results, including both original and revised planned

capital actions.

 Process to Request Reconsideration of the Stress Buffer Requirements. Within 15

calendar days of receipt of the notice of its stress buffer requirements, a CCAR firm may

submit a request for reconsideration.

The request must contain a detailed explanation of

why reconsideration should be granted and all supporting reasons for the request. If the

request includes information that was not originally provided in the capital plan submission,

the request should also explain why the additional information should be considered.

The

Federal Reserve would consider the request and notify the CCAR firm of the decision to

affirm of modify the initial stress buffer requirement within 30 calendar days of receipt of the

notice.

This same process would also apply to a CCAR firm’s request for reconsideration of

a qualitative objection.

The updated stress buffer requirements or the qualitative objection, as applicable, would not

be effective during the pendency of a request for reconsideration.

If the Federal Reserve

has not yet indicated its non-objection for planned capital distributions for a quarter that falls

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within this pendency, then a CCAR firm would be permitted to make capital distributions so

long as they do not exceed the four-quarter average of capital distributions to which the

Federal Reserve indicated its non-objection for the previous capital plan cycle, unless

otherwise determined by the Federal Reserve.

 Modified Assumptions Under the Supervisory Stress Test. In addition to the proposals that

would integrate and simplify the requirements under the capital rules and capital plan rule, the

Federal Reserve proposed several changes to the assumptions it makes in its supervisory stress

tests. These assumptions would impact the projected changes in CET1 capital and tier 1

leverage ratios in the severely adverse scenario of the Federal Reserve’s supervisory stress test

and, therefore, the calculation of the stress buffer requirements.

 Narrowing the Set of Planned Capital Actions Assumed to Occur. Currently, the

Federal Reserve assumes that a CCAR firm will make all of its planned capital actions,

including dividends, repurchases and issuances of regulatory capital instruments. Some

CCAR firms have argued that this assumption is unrealistic and overly distortive, as CCAR

firms are unlikely to continue making planned capital distributions irrespective of the stress

they are under, and fails to take into account that such distributions may not be permitted

under the capital rules. In response to these comments, the Federal Reserve has proposed

narrowing the set of planned capital actions that it will assume occur for purposes of the

stress tests.

The Federal Reserve would no longer assume that a CCAR firm makes any repurchases or

redemptions of any capital instrument, but would effectively retain the assumption that CCAR

firms execute certain planned capital actions because, as described above, four quarters of

planned common stock dividends are factored into the calculation of a CCAR firm’s stress

buffer requirements.

The Federal Reserve notes that the assumption that CCAR firms

would make planned distributions on common stock is consistent with experience in the

recent financial crisis, when banking organizations continued to make distributions on

common stock even as their capital conditions worsened.

The Federal Reserve also

explains that it would expect similar action in any future recessions because publicly traded

CCAR firms would want to avoid the negative stock price reaction that a reduction in

dividends may cause.

The Federal Reserve would continue to assume that a CCAR firm would make payments on

any instrument that qualifies as additional tier 1 or tier 2 capital equal to the stated dividend,

or contractual interest or principal due on such instruments.

It would also assume that a

CCAR firm does not make any planned issuance of regulatory capital instruments, other than

in connection with a planned merger or acquisition (to the extent that merger or acquisition is

reflected in the CCAR firm’s pro forma balance sheet estimates).

In addition to revising these assumptions with respect to the supervisory stress test, the

Federal Reserve would amend the DFAST rules applicable to CCAR firms’ own stress tests

to require CCAR firms to incorporate these assumptions into their DFAST company-run

stress tests as well.

 Assuming a Constant Balance Sheet Under Stress. The proposal would also modify the

Federal Reserve’s assumption with respect to the behavior of CCAR firms’ balance sheets

under stress. The Federal Reserve has generally assumed that CCAR firms’ balance sheets

expand under stress in order to prevent CCAR firms from “shrinking to health” and reducing

the credit supply in periods of stress. Some CCAR firms have noted that this assumption is

unrealistic and overly distortive, both because the credit demand itself would likely contract in

periods of stress, and because the assumption does not account for certain elements of the

balance sheet which are unlikely to grow under stress, for example, legacy portfolios in runoff.

The

Federal

Reserve

proposed

modify

the

balance

sheet

assumption

and

assume

that

the

size

CCAR

firm’s

balance

sheet

remains

constant

under

stress.

As a corollary to this,

the Federal Reserve would also assume that a CCAR firm’s RWAs and leverage ratio

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Bank Capital Requirements, Capital Plans and Stress Tests

April 19, 2018

SULLIVAN & CROMWELL LLP

denominator remain unchanged over the planning horizon. In both cases, there would be

exceptions for changes primarily related to deductions from regulatory capital or changes to

the Federal Reserve’s regulations, as well as the projected impact of a planned merger or

acquisition or completed or contractually agreed-on divestiture.

 Elimination of Heightened Scrutiny for Dividend Payout Ratios Above 30 Percent. The

Federal Reserve has also proposed modifying its treatment of capital plans that imply a common

stock dividend payout ratio above 30 percent.

The Federal Reserve has previously subjected

such plans to heightened scrutiny. Under the proposal, the Federal Reserve would eliminate this

30 percent dividend payout ratio as a criterion for heightened supervisory scrutiny of a CCAR

firm’s capital plan. This elimination, together with other aspects of the proposal, signifies a shift

away from assessing capital adequacy based on the amount of capital payouts, and toward

assessing it based on capital levels, which would grant more flexibility to CCAR firms in their

capital planning going forward.

 Impact Assessment. The Federal Reserve notes that the impact of the proposal would vary

through economic and credit cycles based on the risk profile and planned capital actions of

individual CCAR firms, as well as the severity of the supervisory severely adverse scenario. In

general, the Federal Reserve estimates that the proposal would result in lower CET1 capital

requirements for non-G-SIBs with over $50 billion in assets and result in similar or in some cases

higher CET1 capital requirements for G-SIBs.

Based on data from the 2015, 2016 and 2017

CCAR cycles, the Federal Reserve estimates that the impact of the proposal would range from an

aggregate reduction in required CET1 capital of approximately $35 billion (based on 2017 data) to

an aggregate increase in required CET1 capital of approximately $40 billion (based on 2015

data).

For G-SIBs, the increase in CET1 aggregate capital requirements is estimated to range

from $10 billion (based on 2017 data) to $50 billion (based on 2015 data), but for non-G-SIBs the

decrease in CET1 aggregate capital requirements is estimated to range from approximately $45

billion (based on 2017 data) to $10 billion (based on 2015 data).

The Federal Reserve also estimates that the proposal would generally lower the amount of tier 1

capital required in connection with the assessment of the leverage ratio in stress, although it does

not quantify this estimate.

The proposed modifications to the capital distribution and balance

sheet assumptions in the Federal Reserve’s supervisory stress tests would reduce the projected

fall in a CCAR firm’s tier 1 leverage ratio in stress, and therefore the amount of tier 1 capital

required to pre-capitalize stressed losses, though the inclusion of four quarters of dividends in the

SLB requirement would partially offset the revised capital distribution assumptions. On April 11,

2018 the Federal Reserve and the OCC proposed to recalibrate the eSLR requirements

applicable to U.S. G-SIBs and their subsidiary insured depository institutions that are state

member banks, national banks or Federal savings associations.

That proposal would also

impact the amount of tier 1 capital that CCAR firms that are U.S. G-SIBs are required to hold in

order to avoid limitations on capital distributions and discretionary bonus payments. Although the

Federal Reserve has separately estimated the impacts of the eSLR and stress buffer proposals

on a stand-alone basis, it has not analyzed the cumulative impact of the two proposals. In

particular, the Federal Reserve has not addressed how the elimination of the quantitative

objection and the requirement for certain CCAR firms, including the U.S. G-SIBs, to satisfy the

minimum SLR requirement on a post-stress basis would affect the impact analysis in the eSLR

proposal.

Because the proposal relates only to the capital requirements for CCAR firms, it would not affect

the capital buffer requirements for bank holding companies that are not CCAR firms or for insured

depository institutions, including subsidiaries of CCAR firms.

-10-

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April 19, 2018

SULLIVAN & CROMWELL LLP

ENDNOTES

Federal Reserve System, Amendments to the Regulatory Capital, Capital Plan, and Stress Test

Rules,

available

https://www.federalreserve.gov/newsevents/

pressreleases/files/bcreg20180410a2.pdf (April 10, 2018) (hereinafter, the “Proposal”).

“CCAR” refers to the Federal Reserve’s Comprehensive Capital Analysis and Review of capital

plans filed annually by firms under the Federal Reserve’s capital plan rule, Section 225.8 of

Regulation Y, and supervisory and company-run stress tests under its Dodd-Frank Act Stress

Test (“DFAST”) rules, Subparts E and F of Regulation YY, 12 C.F.R. Part 252.

12 C.F.R. Part 217.

Federal Reserve Staff Memorandum re: Proposed rule regarding the stress buffer requirements

(April 5, 2018) at 2 and 18, available at https://www.federalreserve.gov/newsevents/

pressreleases/files/bcreg20180410a1.pdf.

The qualitative assessment is applicable only to certain firms. In January 2017, the Federal

Reserve eliminated the qualitative assessment for “large and noncomplex” firms (i.e., those that

are not “large and complex”). See Federal Reserve System, Amendments to the Capital Plan

and Stress Test Rules, 82 Fed. Reg. 9308 (February 3, 2017), available at

https://www.gpo.gov/fdsys/pkg/FR-2017-02-03/pdf/2017-02257.pdf. For a discussion of the

amendments, see our Memorandum to Clients entitled Banking Organization Capital Plans and

Stress Tests: Federal Reserve Finalizes Elimination of the Qualitative CCAR Assessment for

Smaller Firms, Reduction in the De Minimis Exception for Additional Capital Distributions, and

Other Notable Revisions to Its Capital Plan and Stress Testing Rules (Feb. 1, 2017), available at

https://sullcrom.com/banking-organization-capital-plans-and-stress-tests-02-01-2017.

12 C.F.R. § 217.11.

12 C.F.R. § 225.8.

For the third quarter of 2019, the proposal would provide that CCAR firms could make capital

distributions that do not exceed the four-quarter average of the capital distributions in their capital

plans for the 2018 CCAR cycle.

As of the publication of this Memorandum, the proposal has not been published in the Federal

Proposal, at 18.

CCAR firms would also have to pre-capitalize stated payments on additional tier 1 and tier 2

capital instruments, such as non-cumulative perpetual preferred stock and subordinated debt,

because the Federal Reserve would continue to assume that a firm makes all such payments in

the supervisory stress tests. Proposal, at 27.

Proposal, at 24.

Id.

Proposal, at 19.

Id.

Basel Committee, Basel III: Finalising post-crisis reforms (Dec. 2017), available at

https://www.bis.org/bcbs/publ/d424.pdf. For additional information regarding Basel IV, please see

our Memorandum to Clients entitled Bank Capital Requirements: Basel Committee Releases

Standards to Finalize Basel III Framework (Dec. 19, 2017), available at

https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Bank_Capital_Requirements_12

192017.pdf.

-11-

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April 19, 2018

SULLIVAN & CROMWELL LLP

ENDNOTES (CONTINUED)

At national discretion, authorities may set the value of the Internal Loss Multiplier equal to a fixed

coefficient of one, with the result that operational risk RWAs and capital requirements are a

function of only the other component, the Business Indicator Component.

For additional information on CECL, see our Memorandum to Clients entitled FASB Expected

Credit Loss Methodology (June 23, 2016), available at https://www.sullcrom.com/client-alert-fasbexpected-credit-loss-methodology.

Federal Reserve, FDIC and OCC, Regulatory Capital Rules: Implementation and Transition of the

Current Expected Credit Losses Methodology for Allowances and Related Adjustments to the

Regulatory Capital Rules and Conforming Amendments to Other Regulations (Apr. 17, 2018),

available

https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20180417a1.pdf.

The

CECL-related proposal will be addressed in a forthcoming Memorandum to Clients.

Proposal, at 1.

Proposal, at 31.

Proposal, at 47-48.

Vice Chairman for Supervision Randal K. Quarles, Semiannual Supervision and Regulation

Testimony (April 18, 2017) at 6 (“Recently, we have solicited comment on whether that approach

[eliminating the qualitative CCAR assessment] should be applied to a broader range of firms. I

believe that our supervisory goal of ensuring a robust capital planning process at most firms can

be achieved using our normal supervisory program combined with targeted horizontal

assessments without compromising the safety and soundness of the financial system.”), available

at https://www.federalreserve.gov/newsevents/testimony/files/quarles20180417a.pdf.

Governor Daniel K Tarullo, Departing Thoughts (April 4, 2017) at 21 (“So I think the time may be

coming when the qualitative objection in CCAR should be phased out, and the supervisory

examination work around stress testing and capital planning completely moved into the normal,

year-round supervisory process, even

for the G-SIB.”), available

https://www.federalreserve.gov/newsevents/speech/files/tarullo20170404a.pdf.

For a discussion of the proposed new LFI rating system, see our Memorandum to Clients entitled

Federal Reserve Proposes New Rating System: Federal Reserve Proposes to Establish a New

Rating System for the Supervision of Large Financial Institutions Designed to Align with the

Supervisory Program for Those Institutions and to Enhance the Clarity and Consistency of

Supervisory

Assessments

(August

2017),

available

https://sullcrom.com/siteFiles/publications/SC_Publication_Federal_Reserve_Proposes_New_Rat

ing_System.pdf.

Advanced approaches CCAR firms are generally those with $250 billion or more in total

consolidated assets or $10 billion or more in foreign exposures. Intermediate holding companies

of foreign banking organizations that meet the advanced approaches definition are not required to

determine their risk-based capital ratios using the advanced approaches.

Proposal, at 19.

Proposal, at 6-10.

Proposal, at 19.

Proposal, at 25.

Proposal, at 20. U.S. G-SIBs are subject to an enhanced supplementary ratio (“eSLR”)

requirement, which includes a 2 percent buffer in addition to the 3 percent minimum. On April 11,

2018 the Federal Reserve and the OCC proposed to recalibrate the eSLR requirements

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Bank Capital Requirements, Capital Plans and Stress Tests

April 19, 2018

SULLIVAN & CROMWELL LLP

ENDNOTES (CONTINUED)

applicable to U.S. G-SIBs and their subsidiary insured depository institutions that are state

member banks, national banks or Federal savings associations. For additional information on

this proposal, see our Memorandum to Clients entitled Bank Capital Requirements: Federal

Reserve and OCC Propose Amendments to the Enhanced Supplementary Leverage Ratio

Requirements

for U.S. G-SIBs

(April 17, 2018), available

https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Bank_Capital_Requirements_04

_17_18.pdf (hereinafter, the “eSLR Memo”).

Proposal, at 20.

Proposal, at 34-36.

For additional information on the eSLR and TLAC buffer requirements, see note 32 and our

Memorandum to Clients entitled Loss Absorbency Requirements: Federal Reserve Adopts Final

TLAC and Related Requirements for U.S. G-SIBs and U.S. Intermediate Holding Company

Subsidiaries

of Non-U.S. G-SIBs

(Dec. 16, 2016), available

https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Loss_Absorbency_Requirement

s_12_16_16.pdf.

Proposal, at 34.

The de minimis exception currently applies on a cumulative basis to capital distributions from the

third through sixth quarters of the planning horizon. The proposal would revise the de minimis

exception to the cumulative net distribution limit so that capital distributions would be measured

against the 0.25 percent limit beginning with the fourth quarter of the planning horizon (12 C.F.R.

§ 225.8(k)(3)(iii)(E) (as proposed), but the de minimis exception to the cumulative gross

distribution limit would continue to measure capital distributions against the 0.25 limit from July 1

of one calendar year through June 30 of the following calendar year (12 C.F.R. § 225.8(k)(2)(i)(C)

(as proposed). The proposal does not address why time periods are different.

Proposal, at 35.

Proposal, at 34.

Proposal, at 47-48. In December of 2017, the Federal Reserve requested comment on a series

of proposals designed to increase the transparency of the supervisory stress tests. These

proposals would provide for enhanced disclosure relating to the supervisory scenarios, but would

not subject the scenarios to public notice and comment. For further discussion of these

proposals, see our Memorandum to Clients entitled Bank Capital Plans and Stress Tests:

Federal Reserve Proposes a New Stress Testing Policy Statement, Several Enhancements to

Supervisory Stress Test Model Disclosure and Amendments to its Stress Testing Scenario

Design

Framework

(Dec.

12,

2017),

available

https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Bank_Capital_Plans_and_Stres

s_Tests_121217.pdf. In recent testimony, Vice Chairman for Supervision Randal Quarles

indicated that the Federal Reserve is considering subjecting the supervisory scenarios to public

notice and comment, stating, “We are continuing to think about how we can make the stress

testing process more transparent without lowering the strength of the test itself or undermining

the usefulness of the supervisory stress test. I personally believe that our stress testing

disclosures can go further, and that we should consider additional measures, such as putting our

stress scenarios out for comment. Vice Chairman for Supervision Randal K. Quarles, Semiannual

Supervision and Regulation Testimony (April 17, 2018) at 9, available at

https://www.federalreserve.gov/newsevents/testimony/files/quarles20180417a.pdf.

Proposal, at 37.

Id.

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Bank Capital Requirements, Capital Plans and Stress Tests

April 19, 2018

SULLIVAN & CROMWELL LLP

ENDNOTES (CONTINUED)

For additional information on SR Letters 15-18 and 15-19, see our Memorandum to Clients

entitled Bank Capital Plans and Stress Tests: Federal Reserve Board Issues Consolidated

Guidance on Supervisory Expectations for Capital Planning at Large Bank Holding Companies

(December

30,

2015),

available

https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Bank_Capital_Plans_and_Stres

s_Tests_12_30_15.pdf.

Last month, the United States Senate approved a bill that would, among other things, eliminate

the adverse scenario as a mandatory scenario in DFAST. See S. 2155, 115th Cong. § 401

(2018), available at https://www.congress.gov/115/bills/s2155/BILLS-115s2155es.pdf. For

additional information, see our Memorandum to Clients entitled Financial Services Regulatory

Reform Legislation: Senate Approves Bipartisan Regulatory Reform Bill (Mar. 18, 2018), available

https://www.sullcrom.com/siteFiles/Publications/SC_Publication_Financial_Services_Regulatory_

Reform_Legislation_3_18_2018.pdf.

Proposal, at 38.

12 C.F.R. § 225.8(h)(5) (as proposed).

Proposal, at 30.

Proposal, at 46-47.

Proposal, at 39.

12 C.F.R. § 225.8(e)(2)(i)(C) (as proposed).

Proposal, at 39.

Id.

Proposal, at 40 (By June 30, “[t]he [Federal Reserve] provides to a firm and publishes initial

notice of the firm’s stress buffer requirements, and for each large and complex and LISCC firm,

the [Federal Reserve’s] decision to object or not object to the capital plan on a qualitative basis.”)

(emphasis added).

Proposal, at 42.

Proposal, at 42-43.

Proposal, at 43.

Id.

Proposal, at 43-44.

Proposal, at 26.

Id.

Proposal at 27.

Id.

Proposal, at 27-28.

Proposal, at 28.

Proposal, at 29.

Proposal, at 28.

Proposal, at 32.

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April 19, 2018

SULLIVAN & CROMWELL LLP

ENDNOTES (CONTINUED)

Proposal, at 33.

Id.

Federal Reserve, OCC, Regulatory Capital Rules: Regulatory Capital, Enhanced Supplementary

Leverage Ratio Standards for U.S. Global Systemically Important Bank Holding Companies and

Certain of Their Subsidiary Insured Depository Institutions: Total Loss-Absorbing Capacity

Requirements for U.S. Global Systemically Important Bank Holding Companies, 83 Fed. Reg.

17317 (April 19, 2018), available at https://www.gpo.gov/fdsys/pkg/FR-2018-04-19/pdf/201808066.pdf.

For more information relating to this proposal, please see the eSLR Memo, supra

note 32.

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April 19, 2018

SULLIVAN a CROMWELL LLP

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