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    Randal Quarles of FED on Refining Stress Capital Buffer Framework

    September 05, 2019

    Randal K. Quarles of FED spoke at the Program on International Financial Systems Conference in Germany. As FED has been considering refinements to the stress testing and capital frameworks, he highlighted that two goals have been at the forefront—to simplify these frameworks to make them easier to apply and understand and to maintain the overall high level of loss-absorbing capacity in the banking system. Last year, FED had issued a proposal on the stress capital buffer (SCB) to simplify regulatory regime by integrating the stress test with the non-stress capital rules. Instead of finalizing the SCB for the 2019 stress test cycle as planned earlier, the SCB framework is now expected to be in place for the 2020 stress tests.

    For large bank holding companies, SCB would replace the fixed-for-all-times-and-for-all-banks 2.5% risk-based capital buffer with a firm-specific buffer based on the most recent stress test results of a firm. This would integrate the stress testing capital requirements with the point-in-time capital requirements. Based on the feedback to the proposal, Mr. Quarles emphasized on two elements of the proposal that he believes should not be a part of the final framework. One of these elements is the requirement for stress leverage buffer and the second element is the requirement for banks to pre-fund the next four quarters of their planned dividend payments. The stress tests currently require banks to set aside sufficient capital to "pre-fund" expected capital distributions, both dividends and repurchases, for all nine quarters of the capital planning horizon. Removing the pre-funding of dividend requirement would simplify the SCB proposal, said Mr. Quarles. 

    As an alternative to requiring pre-funding dividends and in furtherance of the other goals, he suggested two co-equal options that would simplify capital requirements while limiting procyclicality. These two options are consistent with the goal of maintaining the overall levels of capital in the banking system—to set the countercyclical capital buffer (CCyB) at a higher baseline level during normal times and to raise the "floor," or the minimum level, of stress capital buffer. While FED has maintained the CCyB at zero since 2016, other countries have adjusted their CCyB in response to vulnerabilities in their financial sectors or, in the case of the UK, to integrate the CCyB with its structural capital requirements. Under the British framework, the CCyB would equal a positive amount in standard risk conditions. The effect of the policy is that the buffer can be varied in line with the changing risks that the banking system faces over time. He highlighted that the application of the UK approach in the United States could provide a flexible mechanism that could complement other modifications to the SCB framework and allow FED to adjust capital requirements as financial risks are evolving. 

    Mr. Quarles mentioned another equally viable alternative to turning on the CCyB, which involves raising the proposed SCB floor from the fixed 2.5% of risk-weighted assets to a somewhat higher level. This approach would have three significant benefits compared to the CCyB option: greater simplicity, transparency, and predictability. However, the higher fixed floor option has some drawbacks as well. For firms whose losses are typically close to the existing 2.5% floor, this change will affect them more than others and produce a capital regime with slightly less risk-sensitivity. In terms of targeting procyclicality, this approach would be much less direct, as opposed to more actively managing the level of the CCyB. 

    Before finalizing the SCB framework, FED plans to solicit public comment on potential revisions to the SCB proposal from last year, through the standard rule-making process, and this consultation is expected to be launched "in the near future." Mr. Quarles expects that the FED will maintain the basic SCB framework while incorporating some additional refinements, such as to address volatility and provide better notice for firms in planning their capital actions. He concluded that the refinements that are being considered to the SCB framework would improve the efficiency, coherence, and transparency of the regulatory capital framework and the core principles of the stress testing program (that have proven to be successful). 

     

    Related Link: Speech

     

    Keywords: Americas, US, Banking, Stress Testing, CCyB, Stress Capital Buffer, Regulatory Capital, Loss-Absorbing Capacity, Financial Stability, FED

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