Tag: Federal Reserve

US Bank Disclosure Reduced Again

More evidence of the peeling back of US bank disclosure, which may reduce the incentive for bank managements to continually improve their capital and risk management processes.

On 6 March, Moody’s says the US Federal Reserve Board (Fed) announced the elimination of the qualitative objection in its 2019 Comprehensive Capital Analysis and Review (CCAR) for most stress test participants. Only five banks, all US subsidiaries of foreign banks, will remain subject to qualitative objection in the current stress tests cycle. In the past, the Fed has used the qualitative objection to address deficiencies in banks’ capital-planning process. Its elimination is credit negative because it reduces public transparency around the quality of banks’ internal capital and risk management processes.

Under the revised rules, a bank must participate in four CCAR cycles before it qualifies for exemption from a potential qualitative objection in future years. If a firm receives a qualitative objection in its fourth year, it will remain subject to a possible qualitative objection until it passes. For most of the five firms still subject to the qualitative objection, their fourth year will be the 2020 CCAR cycle. In total, 18 firms are subject to this year’s CCAR exercise, with five of them subject to a possible qualitative objection.

All five firms subject to the qualitative assessment in 2019 are foreign-owned intermediate holding companies (IHCs), most of which were first subject to the Fed stress tests on a confidential basis in 2017. If the IHC has a bank holding company subsidiary that was subject to CCAR before the formation of the IHC, then the IHC is not considered the same firm for the purpose of the four-year test.

The Fed noted that since CCAR was implemented in 2011, most firms have significantly improved their risk management and capital planning process. Going forward, its capital-planning assessments will be through the regular supervisory process. The Fed highlighted as an example the new rating system for large financial institutions, which will assign component ratings of a firm’s capital planning and positions. However, these ratings will be confidential supervisory information and unavailable to the public unless the deficiencies are so severe that they warrant formal enforcement action. The new process replaces an independent comparative assessment.

The lack of public disclosure may also reduce the incentive for bank managements to continually improve their capital and risk management processes, which the CCAR qualitative review encouraged.

As previously announced, 17 large and non-complex bank holding companies, generally with $100-$250 billion of consolidated assets, will not be subject to CCAR in 2019 because of the Economic Growth, Regulatory Relief, and Consumer Protection Act (the EGRRCPA), which became law in May 2018. They will next participate in 2020. Most of these banks were removed from the qualitative objection in 2017 and the Fed will only object to their capital plans if they fail to meet one of the minimum capital ratios under the stress scenarios on quantitative grounds.

The Fed’s announcement was incorporated with its release of instructions for the 2019 CCAR cycle. The Fed also provided information on allowable capital distributions for those firms whose CCAR cycle was extended to 2020. For those banks, the Fed published letters that address each bank’s individual 2019 capital plans. The Fed pre-authorized the firms to distribute, net of any issuance of capital, up to the sum of:

  • The additional capital the firm could have distributed in CCAR 2018 and remained above the minimum requirements; plus
  • Capital accretion (change in capital ratios since CCAR 2018); plus
  • its already approved capital distributions for first-quarter 2019 and second-quarter 2019; minus
  • its actual distributions for first-quarter 2019 and planned distribution for second-quarter 2019

This plan is also credit negative because it permits capital distributions based on last year’s results, which incorporated a modestly less stringent severely adverse scenario than the 2019 stress test, and it also fails to incorporate any interim changes in the banks’ risk profiles. If any of the 17 banks wants to distribute more than its maximum pre-authorized amount, it may submit a capital plan to the Fed by 5 April 2019 and will be subject to the 2019 CCAR supervisory stress test.

The Feds’s 2019 Stress Test Parameters

The Federal Reserve Board has released the scenarios banks and supervisors will use for the 2019 Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act stress test exercises. The extreme scenario assumes a short sharp fall, in 2020.

Whilst its a theoretical exercise, kudos to the FED for making public the inputs, and of course they will publish results, to an individual firm level later (unlike or opaque APRA tests, where disclosure remains appalling).

Stress tests, by ensuring that banks have adequate capital to absorb losses, help make sure that they will be able to lend to households and businesses even in a severe recession. CCAR evaluates the capital planning processes and capital adequacy of the largest U.S. bank holding companies, and large U.S. operations of foreign firms, using their planned capital distributions, such as dividend payments and share buybacks and issuances. The Dodd-Frank Act stress tests also help ensure that banks can continue to lend during times of stress, but use standard capital distribution assumptions for all firms. Both assessments only apply to domestic bank holding companies and foreign bank intermediate holding companies with more than $100 billion in total consolidated assets.

The stress tests run by the firms and the Board apply three hypothetical scenarios: baseline, adverse, and severely adverse. For the 2019 cycle, the severely adverse scenario features a severe global recession in which the U.S. unemployment rate rises by more than 6 percentage points to 10 percent. In keeping with the Board’s public framework for scenario design, a stronger economy with a lower starting point for the unemployment rate results in a tougher scenario. The severely adverse scenario also includes elevated stress in corporate loan and commercial real estate markets.

“The hypothetical scenario features the largest unemployment rate change to date,” Vice Chairman for Supervision Randal K. Quarles said. “We are confident this scenario will effectively test the resiliency of the nation’s largest banks.”

The adverse scenario features a moderate recession in the United States, as well as weakening economic activity across all countries included in the scenario.

The adverse and severely adverse scenarios describe hypothetical sets of events designed to assess the strength of banking organizations and their resilience. They are not forecasts. The baseline scenario is in line with average projections from surveys of economic forecasters. It does not represent the forecast of the Federal Reserve.

Each scenario includes 28 variables–such as gross domestic product, the unemployment rate, stock market prices, and interest rates–covering domestic and international economic activity. Along with the variables, the Board is publishing a narrative description of the scenarios that also highlights changes from last year.

Firms with large trading operations will be required to factor in a global market shock component as part of their scenarios. Additionally, firms with substantial trading or processing operations will be required to incorporate a counterparty default scenario component.

Banks are required to submit their capital plans and the results of their own stress tests to the Federal Reserve by April 5, 2019. The Federal Reserve will announce the results of its supervisory stress tests by June 30, 2019. The instructions for this year’s CCAR will be released at a later date.

Also on Tuesday, the Board announced that it will be providing relief to less-complex firms from stress testing requirements and CCAR by effectively moving the firms to an extended stress test cycle for this year. The relief applies to firms generally with total consolidated assets between $100 billion and $250 billion.

As a result, these less-complex firms will not be subject to a supervisory stress test during the 2019 cycle and their capital distributions for this year will be largely based on the results from the 2018 supervisory stress test. At a later date, the Board will propose for notice and comment a final capital distribution method for firms on an extended stress test cycle in future years.

FED Holds Benchmark Rate, “Is Patient”

The US Federal Reserve kept rates on hold in today’s announcement. It also underscores its “patience” in terms of future movements, which is central bank speak suggests the current tightening cycle has ended for now. Plus we suspect the rate of QT will slow too, providing more support to the US economy. They are prepared to QE again if needed! The net result will be for more positive market movements, for now. They also reaffirmed inflation targeting is the core principle behind their management approach.

The Dow was higher (driven also by news from Apple, Boeing and China trade talks as well).

But the Fed also issued an “extra” comment:

After extensive deliberations and thorough review of experience to date, the Committee judges that it is appropriate at this time to provide additional information regarding its plans to implement monetary policy over the longer run. Additionally, the Committee is revising its earlier guidance regarding the conditions under which it could adjust the details of its balance sheet normalization program. Accordingly, all participants agreed to the following:

  • The Committee intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve’s administered rates, and in which active management of the supply of reserves is not required.
  • The Committee continues to view changes in the target range for the federal funds rate as its primary means of adjusting the stance of monetary policy. The Committee is prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments. Moreover, the Committee would be prepared to use its full range of tools, including altering the size and composition of its balance sheet, if future economic conditions were to warrant a more accommodative monetary policy than can be achieved solely by reducing the federal funds rate.

Here is the general release:

Information received since the Federal Open Market Committee met in December indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier last year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Although market-based measures of inflation compensation have moved lower in recent months, survey-based measures of longer-term inflation expectations are little changed.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. In support of these goals, the Committee decided to maintain the target range for the federal funds rate at 2-1/4 to 2-1/2 percent. The Committee continues to view sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes. In light of global economic and financial developments and muted inflation pressures, the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

Do Student Loans Cramp Home Ownership Rates For Young Adults?

In an article, released by the US FED via the first issue of Consumer & Community Context, they explore the impact that rising student loan debt levels may have on home ownership rates among young adults in the US. They suggest that higher debt overall helps to explain lower home ownership.

The home ownership rate in the United States fell approximately 4 percentage points in the wake of the financial crisis, from a peak of 69 percent in 2005 to 65 percent in 2014. The decline in home ownership was even more pronounced among young adults. Whereas 45 percent of household heads ages 24 to 32 in 2005 owned their own home, just 36 percent did in 2014—a marked 9 percentage point drop

While many factors have influenced the downward slide in the rate of home ownership, some believe that the historic levels of student loan debt have been particular impediments. Indeed, outstanding student loan balances have more than doubled in real terms (to about $1.5 trillion) in the last decade, with average real student loan debt per capita for individuals ages 24 to 32 rising from about $5,000 in 2005 to $10,000 in 2014.3 In surveys, young adults commonly report that their student loan debts are preventing them from buying a home.

They estimate that roughly 20 percent of the decline in home ownership among young adults can be attributed to their increased student loan debts since 2005. Our estimates suggest that increases in student loan debt are an important factor in explaining their lowered home ownership rates, but not the central cause of the decline.

Estimating the Effect of Student Loan Debt on Home ownership

The relationship between student loan debt and home ownership is complex. On the one hand, student loan payments may reduce an individual’s ability to save for a down payment or qualify for a mortgage. On the other hand, investments in higher education also, on average, result in higher earnings and lower rates of unemployment. As a result, it is not immediately clear whether, on balance, the impact of student loan debt on home ownership would be positive or negative.

Since we are interested in isolating the negative effect of increased student loan burdens on home ownership from the potential positive effect of additional education, our analysis aims to estimate the effect of debt on home ownership holding all other factors constant. In other words, if we were to compare two individuals who are otherwise identical in all aspects but the amount of accumulated student loan debt, how would we expect their home ownership outcomes to differ?

To estimate the effect of the increased student loan debt on home ownership, we tracked student loan and mortgage borrowing for individuals who were between 24 and 32 years old in 2005. Using these data, we constructed a model to estimate the impact of increased student loan borrowing on the likelihood of students becoming homeowners during this period of their lives. We found that a $1,000 increase in student loan debt (accumulated during the prime college-going years and measured in 2014 dollars) causes a 1 to 2 percentage point drop in the home ownership rate for student loan borrowers during their late 20s and early 30s. Our estimates suggest that student loan debt can be a meaningful barrier preventing young adults from owning a home. Next, we apply these estimates to another interesting question: How much of the 9 percentage point drop in the home ownership rate of 24 to 32 year olds between 2005 and 2014 can be attributed to rising student loan debt?

The Rise in Student Loan Debt and Decline in Home ownership since 2005
Answering this question requires two steps. First, we calculate an expected probability of home ownership in 2005 for each individual in our sample using the estimated model from our previous research. Second, we produce a simulated scenario for the probability of home ownership by increasing each individual’s debt to match the student loan debt distribution of this age group in 2014. The difference between the probabilities calculated in these two steps determines the effect of the increased debt on the home ownership rate of the young, holding demographic, educational, and economic characteristics fixed.

This exercise captures two key dimensions of the shifts in the distribution of student loan debt between 2005 and 2014, in addition to the overall increase in the average amounts borrowed. First, the fraction of young individuals who have borrowed to fund post secondary education with debt has increased by roughly 10 percentage points over this period, from 30 to 40 percent. Second, the amounts borrowed at the upper end of the distribution increased more rapidly than in the middle.

According to our calculations, the increase in student loan debt between 2005 and 2014 reduced the home ownership rate among young adults by 2 percentage points. The home ownership rate for this group fell 9 percentage points over this period (figure 2), implying that a little over 20 percent of the overall decline in home ownership among the young can be attributed to the rise in student loan debt. This represents over 400,000 young individuals who would have owned a home in 2014 had it not been for the rise in debt.

An important caveat to keep in mind when interpreting our estimates is the difference in mortgage market conditions before and after the financial crisis. The model used to develop these estimates was built using data for student loan borrowers who were between 24 and 32 years old in 2005, so a large fraction had made their home-buying decisions before 2008, when credit was relatively easier to obtain. Following the crisis, loan underwriting may have become more sensitive to student loan debt, increasing its importance in explaining declining home ownership rates.

Student Loan Debt May Have Even Broader Implications
for Consumers

There are multiple channels by which student loans can affect the ability of consumers to buy homes. One we would like to highlight here is the effect of student loan debt on credit scores. In our forthcoming paper, we show that higher student loan debt early in life leads to a lower credit score later in life, all else equal. We also find that, all else equal, increased student loan debt causes borrowers to be more likely to default on their student loan debt, which has a major adverse effect on their credit scores, thereby impacting their ability to qualify for a mortgage.

This finding has implications well beyond home ownership, as credit scores impact consumers’ access to and cost of nearly all kinds of credit, including auto loans and credit cards. While investing in post secondary education continues to yield, on average, positive and substantial returns, burdensome student loan debt levels may be lessening these benefits. As policymakers evaluate ways to aid student borrowers, they may wish to consider policies that reduce the cost of tuition, such as greater state government investment in public institutions, and ease the burden of student loan payments, such as more expansive use of income-driven repayment.


US Bank Stress Tests To Be Eased

On 9 January, Moody’s says, the Federal Reserve Board (Fed) proposed revisions to company-run stress testing requirements for Fed-regulated US banks to conform with the Economic Growth, Regulatory Relief, and Consumer Protection Act (the EGRRCPA), which became law in May 2018.

Among the revisions, which are similar to those proposed in December 2018 by the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corp. (FDIC), is a proposal that would eliminate the requirement for company-run stress tests at most bank subsidiaries with total consolidated assets of less than $250 billion. The proposed changes would be credit negative for affected US banks because they would ease the minimum requirements for stress testing at the subsidiary level.

The proposed revisions would also require company-run stress tests once every other year instead of annually at most banks with more than $250 billion in total assets that are not subsidiaries of systemically important bank holding companies. Additionally, the proposal would eliminate the hypothetical adverse scenario from all company-run stress tests and from the Fed’s own supervisory stress tests, commonly known as the Dodd-Frank Stress Test (DFAST) and the Comprehensive Capital Analysis and Review (CCAR); the baseline and severely adverse scenarios would remain.

The proposed changes aim to implement EGRRCPA. As such, we expect that they will be adopted with minimal revisions. In late December 2018, the FDIC and OCC published similar proposals governing the banks they regulate. The stress testing requirements imposed on US banks over the past decade have helped improve US banks’ risk management practices and have led banks to incorporate risk management considerations more fully into both their strategic planning and daily decision making. Without periodic stress tests, these US banks may have more flexibility to reduce their capital cushions, making them more vulnerable in an economic
downturn.

On 31 October 2018, the Fed announced a similar proposal for the company-run stress tests conducted by bank holding companies as a part of a broader proposal to tailor its enhanced supervisory framework for large bank holding companies. Positively, the Fed’s 31 October 2018 proposal would still subject bank holding companies with total assets of $100-$250 billion to supervisory stress testing at least every two years and would still require them to submit annual capital plans to the Fed, even though the latest proposal would no longer require their bank subsidiaries to conduct their own company-run stress tests. Also, supervisory stress testing for larger holding companies would continue to be conducted annually. Continued supervisory stress testing should limit any potential reduction
in capital cushions at those bank holding companies.

We believe that some midsize banks will continue to use company-run stress testing in some form, but more tailored to their own needs and assumptions. Nevertheless, this may not be the view of all banks, particularly those for which stress testing has not been integrated with risk management. Additionally, smaller banks may have resource constraints.

The reduced frequency of mandated company-run stress testing for bank subsidiaries with assets above $250 billion that are not subsidiaries of systemically important bank holding companies is also credit negative, although not to the same extent as the elimination of the requirement for the midsize banks. The longer time between bank management’s reviews of stress test results introduces a higher probability of changing economic conditions that could leave a firm with an insufficient capital cushion.

The Fed’s proposal also would eliminate the hypothetical adverse scenario from company-run stress tests and the Fed’s supervisory stress tests. The market has focused on the severely adverse scenario, which is harsher than the adverse scenario so this proposed change is unlikely to have significant consequence.

FED Announces 2018 Transfer to the US Treasury

The Federal Reserve Board announced preliminary results indicating that the Reserve Banks provided for payments of approximately $65.4 billion of their estimated 2018 net income to the U.S. Treasury. The payments include two lump-sum payments totaling approximately $3.2 billion, necessary to reduce aggregate Reserve Bank capital surplus to $6.825 billion as required by the Bipartisan Budget Act of 2018 (Budget Act) and the Economic Growth, Regulatory Relief, and Consumer Protection Act (Economic Growth Act). The 2018 audited Reserve Bank financial statements are expected to be published in March and may include adjustments to these preliminary unaudited results.

The Federal Reserve Banks’ 2018 estimated net income of $63.1 billion represents a decrease of $17.6 billion from 2017, primarily attributable to an increase of $12.6 billion in interest expense associated with reserve balances held by depository institutions. Net income for 2018 was derived primarily from $112.3 billion in interest income on securities acquired through open market operations–U.S. Treasury securities, federal agency and government-sponsored enterprise (GSE) mortgage-backed securities, and GSE debt securities. The Federal Reserve Banks had interest expense of $38.5 billion primarily associated with reserve balances held by depository institutions, and incurred interest expense of $4.6 billion on securities sold under agreement to repurchase.

Operating expenses of the Reserve Banks, net of amounts reimbursed by the U.S. Treasury and other entities for services the Reserve Banks provided as fiscal agents, totaled $4.3 billion in 2018.

In addition, the Reserve Banks were assessed $849 million for the costs related to producing, issuing, and retiring currency, $838 million for Board expenditures, and $337 million to fund the operations of the Consumer Financial Protection Bureau. Additional earnings were derived from income from services of $444 million. Statutory dividends totaled $1 billion in 2018.

Fed Lifts As Expected

As expected the FED lifted the targets rate today. No real indication of future changes, suggesting a pause perhaps? Here is their statement:

Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has remained low. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee judges that some further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term. The Committee judges that risks to the economic outlook are roughly balanced, but will continue to monitor global economic and financial developments and assess their implications for the economic outlook.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 2-1/4 to 2‑1/2 percent.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

The Dow is currently down significantly, having been higher in the day.

How Persistent Is Financial Distress?

From The St. Louis Fed.

Interesting research from the US, which shows that households who get into financial difficulty may make up a minority of all households, but they tend to stay in this state for an extended period. This is exacerbated by high default fees and charges, and an impatience to consume.

When households lose income unexpectedly, they may skip debt payments (such as credit card payments) rather than lower their consumption. Given that most everyone will experience unanticipated income changes at some point, one may expect that a majority of households fell (at least temporarily) into financial distress sometime between 1999 and 2016. The findings in this post challenge that view: The data show financial distress to be highly concentrated in a relatively small share of the population.

Measuring Financial Distress

We used data from the New York Federal Reserve Consumer Credit Panel/Equifax to show the concentration of debt delinquency across a nationwide sample of people with credit reports. “Total delinquency” refers to the total number of quarters in which people in our sample had debt payments that were 120 days delinquent or more.

The graph below orders the population from least financial distress to most and presents the portion of total delinquency accounted for by every population centile. This is done in two separate lines for credit card debt and for any kind of debt.1

debt delinquency

Debt Delinquency Concentration

The first major fact to emerge is that debt delinquency was highly concentrated over the period 1996-2016. About 60 percent of people never have debt payments 120 days late. On the other extreme, 20 percent of people accounted for 80 percent of financial distress, and around 10 percent of people accounted for 50 percent.

This points to the fact that delinquency is frequent among those who experience it. In fact, more than 30 percent of people who had debt 120 days delinquent at any point in our sample spent at least a quarter of their time in that state.

Effect of Credit Card Delinquency

A second major fact to emerge is that much of the trend in financial distress concentration was driven by credit card delinquency. This makes sense given that credit cards are a widely used debt instrument.

Addressing Financial Distress

In light of the remarkable concentration and persistence of financial distress, it is important for policymakers to be able to disentangle the causes. What factors drive some people to be in financial distress for so long and others to never experience it?

In a working paper titled “The Persistence of Financial Distress,” Fed economists Juan M. Sánchez, José Mustre-del-Río and Kartik Athreya examined this question.2 Specifically, they showed that while traditional economic models of defaultable debt cannot account for the observed concentration and persistence of financial distress, a model which also accounts for high penalty rates on delinquent debt and individuals’ heterogeneity in impatience to consume can do so with a high degree of accuracy.

FED Holds In November (But Expect A Rise In December)

Information received since the Federal Open Market Committee met in September indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Household spending has continued to grow strongly, while growth of business fixed investment has moderated from its rapid pace earlier in the year. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance.

There was no mention of the deterioration in data with policymakers describing household spending growth as strong even though core retail sales stagnated in September. This unambiguously positive outlook is a signal of the central bank’s commitment to raising interest rates. There’s no doubt that the Fed will hike in December, especially if stocks maintain their current recovery.

The T10 Bond Rate went higher.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term. Risks to the economic outlook appear roughly balanced.

In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 2 to 2-1/4 percent.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.

US Bank Capital Requirements Eased

Moody’s says that relaxed regulatory oversight for the largest US regional banks would be credit negative.

On 31 October, the US Federal Reserve (Fed) proposed revisions to the prudential standards for the supervision of large US bank holding companies to implement the Economic Growth, Regulatory Relief, and Consumer Protection Act (the Act) that became law in May of this year. The proposal would apply less rigorous capital and liquidity standards to most large regional bank holding companies with less than $700 billion of consolidated assets or less than $75 billion of cross-jurisdictional activity, a credit-negative.

In particular, the Fed proposals would relax current supervisory requirements for banks with assets of more than $250 billion, which goes beyond the Act’s primary focus on banks below that threshold. However, the proposal is still consistent with the Act’s emphasis on regulation that increases in stringency with a firm’s risk profile, defining four categories of banks as described and named in Exhibit 1 (other firms are no longer subject to the Fed’s enhanced prudential standards under the Act).

The 11 firms in Category IV would be subject to significantly reduced regulatory requirements under the proposal, including public supervisory stress testing every two years instead of annually. These firms would also be permitted to exclude accumulated other comprehensive income (AOCI) from capital and would no longer be subject to the liquidity coverage ratio (LCR) or proposed net stable funding ratio (NFSR) rules. Internal liquidity stress-testing would be required quarterly rather than monthly.

The four firms in Category III would be subject to modestly reduced regulatory requirements under the proposal. They would no longer have to apply the advanced approaches (internal models-based) risk-based capital requirements but would remain subject to the standardized approach requirements. Like Category IV firms, they could elect to exclude AOCI from capital. However, they would still be subject to the annual public supervisory stress tests. Their LCR and NFSR requirements would be reduced to between 70% and 85% of full requirements.

The changes in capital and liquidity requirements for Category III and IV firms are likely to reduce their capital and liquidity buffers, a credit negative. Moreover, the reduced frequency of capital and liquidity stress testing could lead to more relaxed oversight and afford banks greater leeway in managing their capital and liquidity, as well as reduce transparency and comparability, since fewer firms will participate in the public supervisory stress test.

Category I and II firms would not see any changes to their capital or liquidity requirements. The proposals do not address the US operations of foreign banking organizations, but a proposal on their supervision will likely be forthcoming.