Thoughts on the 2022 Supervisory Stress Test
About a month from now the Federal Reserve Board will release the results of its annual supervisory stress tests of large banking organizations. These stress tests will, among other things, be used to calculate the stress capital buffer (SCB) requirements for the firms involved.1
Today’s post is the first in a series discussing a few things I find interesting about the decisions made or yet to be made by the Federal Reserve Board or banking organizations in relation to this year’s test.
A First Time Participant, But No Qualitative Objection
This year marks the first time that certain savings and loan holding companies with $100 billion or more in total consolidated assets are subject to capital planning and SCB requirements, following changes finalized by the Federal Reserve Board in early 2021. As a result of this rule change The Charles Schwab Corporation, the 7th largest banking organization in the country and currently the only covered SLHC above the $100 billion asset size threshold, will have an SCB assigned to it for the first time.
Schwab’s risk-based capital ratios are currently well above regulatory minimums, and ultimately it is not clear how meaningful the SCB will be for Schwab. Indeed, Schwab’s most recent 10-K discloses that risk-based capital ratios are not currently its binding constraint: “Due to the relatively low risk of our balance sheet assets and risk-based capital ratios at CSC and CSB that are well in excess of regulatory requirements, the Tier 1 Leverage Ratio is the most restrictive capital constraint on CSC’s asset growth.”
You could use this as an occasion to debate whether there should be a stress leverage buffer requirement,2 but there is a different aspect of the new rules that I find more interesting.
No Qualitative Objection
Under the Board’s current capital plan rule, neither Schwab nor any other firm that in the future becomes subject to the supervisory stress test will be subject to a potential qualitative objection to its capital plan.3
From one perspective, this makes sense. In 2019 the Federal Reserve Board eliminated the qualitative objection for most firms still subject to it and set out a process through which the qualitative objection would be, and now has been, phased out for other firms. So, the argument goes, because no bank holding companies or intermediate holding companies of foreign banks are now subject to the qualitative objection, the Board is simply treating large covered SLHCs equally to how large BHCs and IHCs are now treated.
This argument has never fully made sense to me, however, in light of the Board’s own stated reasoning in 2019.4 The Board began by noting that although when the qualitative objection was first introduced “many firms supervised by the Federal Reserve had substantial deficiencies in their ability to measure, monitor, and manage their risks” since then “most supervised firms have significantly improved their risk management and capital planning processes.” This justified eliminating the qualitative objection for most firms.
The Board went on to observe, however, that “[f]irms that are newer to the CCAR exercise…may have capital planning capabilities that are less established.” For such firms, the Board concluded that “it would be prudent temporarily to retain the qualitative objection” as a way to allow those firms to further “improve their capital planning practices before the qualitative objection is removed.” Accordingly, the Board decided in 2019 that a firm “must participate in four CCAR exercises and successfully pass the qualitative evaluation in the fourth year to no longer be subject to a potential qualitative objection.”
If you went into the 2021 rulemaking taking the 2019 statements literally, you may have reasonably expected that large firms, or at least certain large firms,5 becoming subject to capital planning requirements for the first time would also be subject to a potential qualitative objection on their first few capital plan submissions.
Why, then, did the Board change course? One possible answer is that this simply does not matter as much as people (this post included) sometimes make out. As the Board has emphasized, even with the qualitative objection eliminated the Board continues to conduct qualitative reviews of large firms’ capital planning practices, and “[f]irms with weak practices may be subject to a deficient supervisory rating, and potentially an enforcement action, for failing to meet supervisory expectations.” Add in the fact that the Board under Chair Yellen - and Governors Tarullo, Powell and Brainard - was expressing misgivings about the public focus on the qualitative objection as early as September 2016,6 and you can see why there may not have been appetite to re-open the qualitative objection process so soon after the Board thought it was finally done with it.
The first possible explanation has some truth to it, but a second explanation might also be in play. Although the 2019 release referred only to “firms newer to the CCAR exercise,” those firms all had one thing in common: each was the intermediate holding company subsidiary of a foreign banking organization, several of which had spent the past decade in various degrees of public and non-public supervisory trouble. You can also see hints of this in the Board’s November 2018 Supervision and Regulation report, which noted that although “the number of outstanding supervisory findings have generally decreased…MRAs and MRIAs have actually increased for large foreign banking operations (FBOs), reflecting changes in regulation that required substantive changes to their U.S. structures.” So maybe in 2019 the Board was just being polite. Maybe the concern was not firms newly subject to the capital plan rule as a general matter, but was instead more specific to certain of the foreign firms which at that time were still relatively new to the process.7 If this explanation is correct, it would go some way to explaining the difference between the statements made in the 2019 rulemaking and the decision made in 2021.
Will Anyone Appeal?
Under the SCB framework in place since 2020 a firm is permitted to request reconsideration of the SCB assigned to it. In 2020, five firms went through the appeal process. All five appeals were denied. In 2021, one firm went through the appeal process. It too was denied.
The Board’s letters denying the requests for reconsideration8 indicate that the bar a request for reconsideration must clear is quite high. Specifically, the Board considers “whether the request identified any errors in the firm’s stress test results and whether each stress test model identified in the firm’s request is operating as intended, within the bounds of the Board’s published policies.”9
As a result, setting aside instances where the Board just got the math wrong,10 most appeals by large banking organizations are likely to have a tough time. The most frequently raised complaints about the stress tests are not about whether the models are operating as intended and consistent with the Board’s published policies, but instead are about features of the models and policies in the first place.11
This is not intended as a criticism of the Board’s approach. Assuming for the sake of argument that the Board’s modeling assumptions and policies do in fact need to be changed, an after-the-fact process driven by individual firm’s appeal decisions is not the best way to make such changes. Moreover, the Board has said that it will direct its staff “to conduct a closer examination of issues raised in the reconsideration process to inform continuing improvements in its stress testing methodology for next year's stress tests,” and thus the appeal process may produce public benefits, even if the results are not seen immediately.
It does raise an interesting dilemma for any firms that are assigned higher-than-anticipated SCBs this year, however. On the one hand, there is the view held by some shareholders that, frankly, you are a wimp if you don’t request reconsideration:
Mike Mayo, analyst at Wells Fargo, said the Fed’s models were so at odds with reality that Goldman had a duty to shareholders to contest them.
“You have a fantastic record [on managing risk] and now you’re going to let the Fed . . . make you have the highest capital requirements because of some assumptions that aren’t even clear to them or to us?” Mr Mayo said. “Why are you lying down and taking this?”
On the other hand, that was in 2020 and before anyone got a look at the Board’s process for considering appeals. The conventional, though certainly not universal, wisdom now may have swung to a view that the reconsideration process is in effect something less like a legal appeal and instead something more like a comment letter on the Board’s stress testing models and policies. In other words, something useful for staking out a position but unlikely to result in immediate substantive changes. If that view prevails, it is not clear if this year any banking organizations will be able to internally justify spending senior management time and resources on requests for reconsideration (or feel the need to externally justify to their shareholders not having done so).
Oversimplifying somewhat, the SCB is a capital buffer requirement that applies in addition to a firm’s minimum common equity tier 1 (CET1) risk-based capital requirement. Subject to a floor of 2.5%, a firm’s individual SCB is calculated as: (1) the difference between the firm’s starting and minimum projected CET1 capital ratios under the severely adverse scenario in the supervisory stress test, plus (2) four quarters of planned common stock dividends as a percentage of risk-weighted assets. See the Board’s adopting release for the final rule or, for something shorter, the staff memo regarding the final rule.
Personal opinion disclosure: I think it is a relatively close call but ultimately I find the anti case (see this 2019 speech from then Vice Chair for Supervision Quarles for a representative example) more persuasive than the case made by those on the other side.
The qualitative objection was the process through which the Federal Reserve Board could object to a firm’s capital plan, and thus limit the firm’s capital distributions, not because of a failure to maintain stressed capital above minimum levels (a “quantitative” objection) but because of weaknesses in the firm’s capital planning practices such as unresolved material supervisory issues, inappropriate assumptions and analyses underlying the capital plan, or inadequate governance and internal controls, risk management and risk identification in support of a firm’s capital planning practices. See here from 2018 for a more complete description.
The quotes in the paragraphs that follow come from either or both of the Board’s press release announcing the change and the supplementary implementation accompanying the final rule.
In January 2017, the Board eliminated the qualitative assessment for large and noncomplex firms, without special phase-out rules for firms that were newly subject to capital planning requirements. In that sense, then, newly covered SLHCs (or BHCs, in future years) are being treated equally to how large and noncomplex firms (a definition no longer used by the Board) have been treated since 2017. Maybe that argument works for other firms that will in future years become subject to the stress test, but it doesn’t really work here: under the then-operative definitions Schwab would not have been a large and noncomplex firm and as such would not have benefitted from the 2017 relief, making the better point of comparison the large and complex firms which were subject to the phase-out announced in 2019.
From the 2016 proposing release: “In the feedback meetings that the Board held on CCAR, participants from large and noncomplex firms expressed the view that the CCAR qualitative assessment was unduly burdensome because, in their view, it required the development of large amounts of documentation and sophisticated stress test models to the same degree as the largest firms in order to avoid a public objection to their capital plan. Consistent with this feedback, further tailoring of regulatory requirements for large and noncomplex firms would avoid creating a risk, based on the high public profile of the CCAR qualitative review, that large and noncomplex firms will over-invest in stress testing and capital planning processes that are unnecessary to adequately capture the risks of these firms.” (emphasis added).
For example, in 2018 the intermediate holding company subsidiary of Deutsche Bank failed the stress test on the grounds that it had “widespread and critical deficiencies across [its] capital planning practices,” with “material weaknesses” in “data capabilities and controls supporting the firm’s capital planning process; in approaches and assumptions used to forecast revenues and losses arising from many of its key business lines and exposures under stress; and in the firm’s risk management functions, including model risk management and internal audit.”
This latter part of the analysis is performed by a group “composed of staff members from across the Federal Reserve System who are subject-matter experts and are not involved in supervisory modeling. This group’s model validation process includes reviews of model performance; conceptual soundness; and the processes, procedures, and controls used in model development, implementation, and the production of results.” See footnote 16 here.
Unlikely, but it happens sometimes.
Just to take one example, in 2020 a few firms argued that certain changes to the Board’s stress testing models should have been phased in immediately, notwithstanding the Board’s Stress Testing Policy Statement which says that highly material changes to the Board’s stress testing models are to be phased in over two years (see Section 2.3). The Board’s public response to these arguments was pretty cursory, saying simply that it would stick to the two-year phase in approach it had articulated in its Policy Statement. See Section III.1 of the Citizens decision letter and Section III.5 of the Goldman decision letter.