The Federal Reserve is reducing the volatility of stress tests for the nation’s largest financial institutions, Federal Reserve Vice Chair for Supervision Randal Quarles said during a Nov. 9 speech at the Brookings Institution in Washington, D.C.
The Fed is proposing changes that are designed to roll back Obama-era financial regulation, which consists of an annual procedure in which the Fed grades banks on their ability to withstand a severe economic crisis.
Since the Great Recession, the combination of the Fed’s procedure, financial firms’ own stress tests, and supervisory oversight over the firms’ practices have “resulted in a meaningful increase in the post-stress resiliency of large financial institutions,” Quarles said. “All of these core components will remain in place.”
However, the Fed is acknowledging banks’ outcry for more transparency and consistency with the tests. “One concern frequently expressed is that the results of the supervisory stress test can lead to capital requirements that change significantly from year to year, which limits a firm’s ability to manage its capital effectively,” Quarles said.
In addition to a lack of consistency, the Fed is looking to revamp specific aspects of the stress tests including streamlining the testing process and reducing the stigma around failing the tests. To that end, a proposed change includes letting banks know the results of its stress tests before planning further capital distributions.
Banks typically have to submit capital distribution requests to the Fed immediately following a stress test, forcing them to provide the agency with a formal plan for dividends and stock repurchases without knowing their effective capital requirement.
“If it guesses wrong, it could be publicly shamed for failing the stress test — if its dividends are too high relative to capital,” Quarles said. “Or [banks are] penalized in the markets for inadequate distribution of income — if its dividends are too low relative to capital.”
The reasoning behind the practice was initially a way for firms to think about their capital uses and needs in developing capital distribution plans, rather than rely primarily on the results of the supervisory stress test to guide those plans.
Now that financial institutions have several years of experience with the current system, firms have told the Fed that they would be able to engage in more thoughtful capital planning if they knew that year’s stress test results before finalizing their distribution plans for the upcoming year.
“I am sympathetic to their concerns,” Quarles said, noting adjustments to capital distribution requirements would not go into effect before 2020.
To view Quarles’ full speech titled, “A New Chapter in Stress Testing,” click here.