Four months after announcing plans for minimal changes to its stress tests, the Fed last Thursday screwed up its courage and proposed a couple of them. The remaining, still-small changes will come after the Fed rests up, but none of this seemingly-strenuous effort addresses the fundamental problem with both capital regulation and the testing designed to ensure it suffices: none of these rules make total sense on its own and all of them taken together are a cacophony of competing demands and ongoing collisions with other standards. Prettying up the stress-test rule is thus only putting ribbons on a ragged assemblage of ill-fitting pieces in clashing colors with large, large holes.
Now-ousted VCS Michael Barr promised a “holistic” capital construct during his 2022 confirmation hearings, but he nonetheless clung tightly to one-off rulemakings without any cumulative-impact analysis. Mr. Barr thus opposed last week’s stress-test changes, but for all the wrong reasons. He thought they went too far; in fact, they don’t go anywhere near as far as they could and should.
The new stress-test proposal most substantively says that banks will henceforth be judged by a three-year rolling average of their tested capital levels, rather than on the current, volatile annual schedule. But, averaging numbers that don’t make sense tells one nothing about the utility of each test. Think about a household with two chihuahuas – average dog weight about ten pounds. Next year, a Labrador romps in, and the average goes up, but the yard can still hold three thirty-pound dogs – what the second-year average says you have. Now in year three, you get a mastiff. The average goes up more than a bit, but you appear to have only four fifty-pound dogs even though the mastiff knocks out every fence you’ve got in year three. No worry, though – if you add another Lab in year four – your rolling average goes down even if the fence is not well-repaired and two labs plus one mastiff is a very different fence-risk proposition.
Averaging thus doesn’t make stress-testing any more meaningful – its sole benefit is facilitating more effective capital planning at covered banks. Fine, but making stress-testing easier isn’t the same as making it better.
The Fed may think averages aren’t as risky as they are because it still mandates that each year’s stress-test results factor into calculating the stress-capital buffer (SCB) calculation that sets regulatory-capital minimums for the biggest banks. This “buffer” is anything but – the stress-tested capital results were initially supposed to define the extra capital a bank needs to weather the worst. However, using stress tests to set minimums without the benefit of complex SCB calculations omitted some prized features of the Basel III Accord even though several of these – i.e., the capital-conservation buffer – were designed for nations with very different banking systems and standards. If the U.S. is better than the expectations on which global rules are posited, then U.S. rules are unduly and unnecessarily burdensome if they also ape Basel, doing little for U.S. banks but making it even easier for nonbanks to run circles around them.
And, other than the fact that Basel wants one, why also add a GSIB surcharge to tough U.S. stress-test and SCB results? Are testing and buffering too flawed to handle complex banking organizations? If they are, then regulators should address resolvability which is the real worry about systemic banks, not under-capitalization. Indeed, trying to use capital to solve for complexity risk and doing so with no regard for stress-test or SCB buffers is nothing but a hot mess. Banks won’t get safer even as the financial system becomes riskier.
Last month, I drew on Federal Reserve Bank of New York research proposing an approach based on “economic capital,” I designated the first unified theory of bank regulation. I’ve hammered on this point more than a little ever since because I believe it resolves much of what’s amiss with the risk-based, leverage, surcharge, and stress-testing standards singly and as a whole.
This is a big-think ill-suited for agencies that take months and even years to do just a little bit of this or that. It’s fine to make current rules less burdensome. But, only doing this masks the fact that the regulatory construct just gets still worse for even longer. Economic capital might not be the right way to go, but we’ll only know if the agencies carefully consider it and lay out a clear, cumulative rationale for things more or less as they are in the financial system sure to become even more dependent on nonbank financial intermediation and a few even-bigger banks.