Daniel K Tarullo: Next steps in the evolution of stress testing
Speech by Mr Daniel K Tarullo, Member of the Board of Governors of the Federal Reserve
System, at the Yale University School of Management Leaders Forum, New Haven,
Connecticut, 26 September 2016.
* * *
Supervisory stress testing has become a cornerstone of post-crisis prudential regulation.
Stress testing, unlike traditional capital requirements, provides a forward-looking assessment
of losses that would be suffered under adverse economic scenarios. The simultaneous
testing of the largest firms lends a perspective on a large part of the banking system and
facilitates identification of common exposures and risks.
During the financial crisis, the success of an ad hoc stress test in assessing the capital needs
of, and restoring confidence in, the nation's largest financial institutions encouraged
Congress to make stress testing a required and regular feature of large firm prudential
regulation.1 The Federal Reserve has, in the succeeding years, substantially refined its
supervisory stress test. Moreover, the stress test has been integrated into our
Comprehensive Capital Analysis and Review (CCAR), which both ties the results of the test
into the banks' capital distribution practices and evaluates their risk management and capital
planning capacities.
Today I want to share with you the results of an extensive review of the statutory stress test
and CCAR programs, which we began following the end of the 2015 cycle. Before turning to
the reasons for that review and some ideas for changing these programs that have arisen
from it, I will take a few moments to summarize the characteristics and purposes of the
programs as they have evolved to this point.
Stress testing and CCAR today
As we have implemented the requirement mandated by the Dodd-Frank Wall Street Reform
and Consumer Protection Act (Dodd-Frank Act) for stress testing - which the Federal
Reserve denominates as the Dodd-Frank Act Stress Test (DFAST) - that exercise includes
four main steps.2 (1) The firms subject to DFAST provide the Federal Reserve with detailed,
significantly standardized data on their loans, securities holdings, trading positions,
counterparty exposures, revenue, expenses, and balance sheets. (2) The Federal Reserve
specifies hypothetical macroeconomic and financial market scenarios - including an
"adverse" and a "severely adverse" scenario. (3) The Federal Reserve inputs the data from
the firms into its own supervisory models to project each firm's losses, revenues, and capital
over a nine-quarter planning horizon under the specified scenarios. (4) The results of the
exercise, including the capital positions of the firms following the hypothesized stress
scenarios, are disclosed to the public.
As DFAST has evolved, it has become an increasingly valuable tool for evaluating whether
the largest financial firms are holding sufficient capital to continue providing credit in the
event of significant macroeconomic and financial stress. However, in itself DFAST does not
set any capital ratios or limit any capital actions by the firms. Those functions are
implemented through the CCAR program, which was created through the regulatory process
by the Federal Reserve.3 In CCAR, the Federal Reserve assesses the overall capital
adequacy of the firms - including evaluations of whether each firm's capital provides an
adequate buffer for the losses that would be incurred during the stress scenarios, whether its
risk management and capital planning processes are appropriately well-developed and
governed, and how its plans to distribute capital through dividends or share repurchases
could affect its ability to remain a viable financial intermediary in the hypothesized scenarios.
Given how central these considerations are to effective risk management and the soundness
of these firms, we are progressively integrating the qualitative elements of CCAR into our
year-round supervisory program for the largest banking organizations.
Under CCAR, the Federal Reserve may object to a firm's capital plan on either quantitative
or qualitative grounds. A quantitative objection is made when the stress test reveals that a
firm would not be able to maintain its post-stress capital ratios above the regulatory minimum
levels over the planning horizon, taking into account its planned capital distributions. We
have taken planned distributions into account because, as the run-up to the financial crisis
revealed, firms may be reluctant to cut their distributions - particularly dividends - even in a
period of growing stress. Thus, CCAR included what has been called a "pre-funding"
requirement.
The Federal Reserve may object on qualitative grounds if it finds that the firm's capital
planning processes are not sufficiently reliable. The qualitative assessment includes the
assumptions and analyses underlying each firm's capital plan, its controls and governance
processes, and whether previously identified weaknesses in management and operations
have been corrected. If the Federal Reserve objects on quantitative or qualitative grounds,
the firm may not make any capital distributions without our permission. In practice, in the
case of a qualitative objection, we have generally permitted distributions at the previous
year's level but no increases. This practice, however, has been in the context of distributions
rising from generally low levels coming out of the crisis; there has been no guarantee that a
similar practice would prevail as distributions continue rising.
The quantitative component of CCAR, based as it is on the DFAST stress tests, has
contributed to the continued strengthening of the capital levels of the largest financial
institutions that began after the original stress test in the winter of 2009.4 While,
understandably, many focus on the quantitative side and its implications for capital
distributions, the importance of the qualitative component has been perhaps
underappreciated. We saw during the 2009 stress test that many large financial institutions
were unable to marshal the data necessary to gauge their own exposures accurately or to
project the adverse effects they would suffer in a tail event, as opposed to a more ordinary
cyclical downturn. CCAR has required the firms to steadily improve their risk management
and capital planning processes. Indeed, some of the firms - particularly the less complex
banks within the CCAR cohort - are now meeting, or are close to meeting, our supervisory
expectations across a range of risk management and capital planning processes.
The CCAR review
Clearly, then, we regard the stress testing and CCAR programs to have made substantial
contributions to protecting the safety and soundness of the nation's largest financial firms
and to promoting the stability of the financial system as a whole. But, equally clearly, if a
stress testing regime is to continue to play this role, it must be dynamic. The hypothesized
scenarios must change to take account of new economic and financial risks. The supervisory
model may, in some circumstances, need to be changed to take account of evolving
economic conditions and bank portfolio characteristics. Additionally, we have been refining
the stress testing and CCAR processes in what is, of course, still a relatively new regulatory
and supervisory tool. Changes of all these kinds have been, and will continue to be, made
from year to year.
After five years of post-crisis stress testing, however, we believed it was important for us to
conduct a more thorough assessment of the program. Taking advantage of the shift in timing
of the annual stress tests following the 2015 cycle, we undertook an overall review.5 We
knew there were several areas to which attention was needed. These included the imperfect
alignment of CCAR with the regulatory capital requirements as they had evolved since we
began stress testing, the desire for additional macroprudential elements in the stress test,
and the qualitative component of CCAR as it applied to less complex firms.
But we also wanted to hear what others thought. Accordingly, we met with bank officials,
debt and equity-side market analysts, public interest groups, and academics - both to solicit
their views on the topics I noted a moment ago and to hear their overall evaluation of, and
recommendations for, our stress testing and CCAR exercises. As you can imagine, we
received a wide range of suggestions, at least some of which were inconsistent with one
another. In the main, though, these discussions reflected strong support for stress testing,
reinforced our going-in view of the key issues for consideration, and presented us with some
other areas for possible change. Before describing the package of potential changes that is
emerging from our review, let me explain a bit more about each of the key topics.
First is the fact that CCAR has been adjusted to align with some, but not all, of the important
changes made in our regulatory capital rules over the past six years.6 One might decide that
the regulatory capital rules and CCAR should be different, complementary capital measures,
roughly the way that a leverage ratio requirement and risk-weighted capital requirements are
complementary. In some particulars, though, CCAR sits a bit uneasily alongside the ongoing
capital requirements. The most notable example is that CCAR assumes that a firm will
continue to make its planned capital distributions during a stress period even though the
regulatory capital rules now include a capital conservation buffer to limit such distributions.
Another is that, to this point, CCAR has not reflected the firm-specific capital surcharge we
have adopted for global systemically important banks (GSIBs).
Our second key topic was the macroprudential dimension of the stress testing and CCAR
regimes. One of the most important lessons of the financial crisis was that prudential
regulation, including capital regulation, had been dominantly microprudential in nature, even
for the largest firms. That is, the regulation was designed and applied with a view mostly to
the idiosyncratic risks faced by a bank in isolation, without regard to the interaction of the
bank and the financial system as a whole. Thus, for example, capital regulation did not take
account of fire sale effects - the reduction in portfolio values for one bank by other banks
selling certain types of assets in order to enhance their own solvency or to counter a
reduction in funding availability. Similarly, microprudential capital regulation allows a bank to
meet its capital ratios by reducing lending - that is, by reducing the denominator of its ratio -
as well as by increasing capital. If many banks were to follow this strategy, even creditworthy
borrowers would be adversely affected, thereby exacerbating an economic downturn.
Our stress testing and CCAR regimes do have some macroprudential elements, which have
been modestly enhanced over the past few years. By conducting the stress tests for all large
banks at the same time under common scenarios, we can evaluate the collective losses that
may be borne by a major part of the industry in the stress scenario. We vary scenario design
to take account of a variety of risks to the financial system and in a way that reduces
procyclical effects.7 We vary the market shock over time to reduce the incentive for firms to
correlate their asset holdings or adopt correlated hedging strategies that are treated relatively
favorably under one particular market shock scenario. And we do not allow firms to plan on a
reduction in their balance sheets as a way to meet capital ratio requirements under stress.
Still, as currently conceived and implemented, our stress testing regime emphasizes the
direct risks to bank capital from a severe recession and associated market dislocation via the
usual channels of reduced operating revenues combined with credit, market, counterparty,
and operational losses. However, as noted by some academics and policy analysts, a fully
developed macroprudential dimension to stress testing would incorporate indirect risks to
bank capital through channels such as market-wide funding and liquidity disruptions, fire
sales, and so on.8 These amplification effects are obviously particularly important for firms
that have relatively larger trading books or that rely relatively more on short-term funding, or
both. Indeed, many of the academics with whom we discussed stress testing during our
review emphasized the importance of building out the macroprudential elements of our stress
testing program.
The third topic we had identified for review was the nature of the qualitative assessment as it
applied to the relatively smaller, less complex firms within the CCAR exercise. While we had
always explicitly differentiated our risk management and capital planning expectations for
these firms, our supervisors had observed that many such firms seemed uncertain of
whether they would nonetheless be held to the more stringent standards intended for the
largest, most complex firms. In the course of our review, comments from these smaller, less
complex firms confirmed this observation. Officials from these banks expressed the view that
the CCAR qualitative assessment was unduly burdensome because it created pressure to
develop complex processes, extensive documentation, and sophisticated stress test models
that mirrored those in use at the largest, most complex firms, in order to avoid the possibility
of a public objection to their capital plan. Since our intention had never been to create an
incentive for firms with a relatively small systemic footprint to invest in stress testing
processes appropriate only for larger or more complex firms, we knew we needed to address
this problem.
Results of the review
After more than a year of discussions and analysis, we have developed ideas for changes to
the stress testing and CCAR regimes that would address these three key issues, along with
some related matters that arose during the course of our review. Some of these changes
would need to be pursued through rulemakings, including the usual notice-and-comment
process. Others can be implemented through nonregulatory changes, though some will need
further elaboration in moving from idea to concrete practice. Thus, there is a necessarily
provisional character to the package set forth here. Except for the relief from the qualitative
requirements for smaller, less complex CCAR firms - which I will describe a bit later - we do
not contemplate proposing regulations to implement these ideas until early next year. Thus,
any such changes would not apply to the coming 2017 DFAST/CCAR cycle.
Better alignment of CCAR with the new regulatory capital rules
As I noted earlier, there have been significant additions to regulatory capital requirements
since the first CCAR exercise began in late 2010. While some - such as revised
riskweighted asset calculation methodologies and definitions of capital - have been integrated
into the stress testing program, other important additions have not. Most significant are the
various capital buffer requirements that sit atop the regulatory minimum levels. These include
a uniform 2.5-percent capital conservation buffer (CCB), the GSIB surcharge, and a
countercyclical buffer that can expand the CCB for a broad range of firms in times of
increasing financial vulnerabilities.9 Firms that do not hold capital sufficient to meet or exceed
this combined buffer level are subject to restrictions on their capital distributions and bonus
payments to executives, which become progressively stricter as their capital level falls
deeper into the buffer.
To better align CCAR with the regulatory capital rules as they now stand, we will be
considering adoption of a "stress capital buffer" (SCB) approach to setting post-stress capital
requirements that would further integrate our capital rules with our stress test and CCAR
frameworks. The simplest way to describe it is that the SCB would replace the existing
2.5 percent CCB as a component in each CCAR firm's point-in-time capital requirements.
The SCB would be risk-sensitive and vary across firms, based on the results of the annual
stress test. Specifically, it would be set equal to the maximum decline in a firm's common
equity tier 1 capital ratio under the severely adverse scenario of the supervisory stress test
before the inclusion of the firm's planned capital distributions, a simplification from the current
practice of calculating the capital positions of the firm separately for each quarter in the
scenario horizon.
As is now the case with the CCB and other applicable capital buffers, a firm would be subject
to restrictions on its capital distributions whenever its capital levels fall below the combined
regulatory minima and buffers. Although it is likely that the stress test losses will continue to
exceed 2.5 percent of risk-weighted assets for most GSIBs, the SCB would have a specified
floor at this current CCB level to avoid any reduction in the stringency of the regulatory
capital rules. A firm's buffer requirement would be recalculated after each year's stress test,
and its capital plan would not be approved in CCAR if the plan indicated that the firm would
fall into the buffer under the stress test's baseline projections.
Let me use a hypothetical example to illustrate how the SCB would work. Assuming that a
firm's common equity tier 1 capital ratio declines in CCAR's severely adverse scenario from
13 percent to 8 percent, that firm's SCB would be the greater of 2.5 percent or the 5 percent
decline - thus, 5 percent. Assuming further that this firm is a GSIB with a surcharge of
3 percent and that the countercyclical buffer is not in effect, the firm would be constrained in
making capital distributions that would bring its common equity tier 1 capital ratio under
12.5 percent. The 12.5 percent figure is the sum of the 4.5 percent minimum common equity
tier 1 risk-weighted capital requirement, the 3 percent surcharge, and the 5 percent stress
loss as calculated in annual stress test.10
Because the GSIB capital surcharge already exists as an additional buffer requirement in the
regulatory capital rules, the stress capital buffer approach would effectively add the GSIB
capital surcharge to our estimates of the amount of capital needed under stress. This would
generally result in a significant increase in capital requirements applicable to the GSIBs, for
most of which CCAR has been their binding capital constraint. But having both the stress
loss buffer and the capital surcharge included in our capital requirements is wholly consistent
with the reasons for having a capital surcharge in the first place. Indeed, not having the two
together has actually been an anomaly that arose from the sequencing of the various capital
strengthening measures we have undertaken.
The Board adopted the GSIB surcharge requirement as part of its implementation of section
165 of the Dodd-Frank Act, which established the important macroprudential principle that
financial firms should be subject to increasingly stringent regulation as their systemic
importance increases. As explained in more detail in the white paper that accompanied the
Board's final GSIB risk-based capital surcharge rule,11 the material distress or failure of a
GSIB would have an adverse impact on the financial system as a whole that is far greater
than the impact on the financial system of the distress or failure of a non-GSIB banking firm.
Accordingly, GSIBs should face capital surcharges to compel internalization of those external
costs. This should reduce the probability of a GSIB's failure enough below that of a
nonGSIB that the expected impact on the system of a GSIB and a non-GSIB failure are more
comparable.
Because the difference in the external costs of the distress or failure of a GSIB as compared
to a non-GSIB is likely to be at least as high during times of macroeconomic and financial
market stress as during ordinary times, there is no reason why the GSIB surcharge should
not be a part of the post-stress capital regime. A complementary point is that the extra buffer
required by the GSIB surcharge also reflects the fact that even the best-conceived annual
stress scenarios cannot capture all tail risks in the financial system. The integration of capital
rules and the stress test thus advances our second aim in initiating our CCAR review - the
incorporation of more macroprudential elements.
As some of you may know, Chair Yellen and I have, on a number of occasions over the past
year or so, indicated publicly that we would be considering the effective incorporation of the
surcharge into post-stress capital expectations. Some industry representatives have
subsequently argued that this step is not warranted. While we will of course address these
and other comments as our rulemaking process moves forward, I want to comment now on a
couple of arguments, since they seem to reflect a misunderstanding of our stress testing
program or of the regulatory structure established by the Dodd-Frank Act.
One such argument is that it is duplicative to include both the anticipated losses under stress
and the GSIB surcharge in a firm's capital requirement because two elements of our current
stress test, the global market shock and the counterparty default shock, only apply to GSIB
firms. However, these additional scenario components capture direct losses to which any
firm engaged in material trading activity is exposed. The market shock measures the trading
mark-to-market losses associated with sudden changes in asset prices. The large
counterparty default measures the losses associated with repricing counterparty exposures
based on the market shock, and then assuming the default of the counterparty that
represents the largest net exposure. These components of the stress test do not capture the
adverse impact of a GSIB failure on the financial system as a whole - the risks that are the
basis for the GSIB surcharge.
These components of our stress test currently apply only to GSIBs because GSIBs are the
only firms currently in CCAR for which these exposures are material. Non-GSIBs currently do
not have material trading activities and so would suffer only small direct trading losses as a
result of severely stressed market conditions or the failure of a major derivatives or
repurchase agreement (repo) counterparty. As the U.S. intermediate holding companies of
foreign banks with more material trading businesses in their U.S. operations are added to
CCAR, we intend to revisit whether the global market shock and counterparty default
component should be applied to firms beyond the U.S. GSIBs.
Another argument offered against inclusion of the surcharge as an element of post-stress
capital expectations is that the material distress or failure of a GSIB no longer poses a
significant threat to financial stability due to the regulations and supervisory programs that
are designed to improve GSIB resolvability. These measures include, among others, the
proposed total loss absorbing capacity (TLAC) rule, the proposed qualifying financial
contracts early termination rule and related International Swap and Derivatives Association
(ISDA) protocols, and efforts to ensure firms engage in strong recovery and resolution
planning.
It is true that these efforts have improved GSIB resolvability in recent years. But these efforts
are ongoing, rather than complete. More importantly, while there is certainly a relationship
between the goals of strengthening the resiliency of the most systemically important firms
and making them more readily resolvable should they nonetheless fail, those are still
separate regulatory aims. The demise of a very large financial institution would cause
substantial damage to the economy and the financial system even if it was not so disorderly
as to threaten the system entirely. Note, in this regard, that the Dodd-Frank Act requires both
more stringent prudential standards for systemically important firms and a process for
promoting the orderly resolution of these same firms. While the complementarity of these and
other elements of a regulatory program always warrant consideration, and while adjustments
in all aspects of the program should be made as conditions and practices evolve, current
work on orderly resolution is surely no argument against the promotion of systemic stability
and macroprudential aims by integrating the surcharge requirement with CCAR.
Changes to the treatment of planned dividends and share repurchases
The shift to a stress capital buffer approach would provide a mechanism for addressing two
issues related to capital distribution limitations under CCAR. The first is the arguable
inconsistency between, on the one hand, the existing CCAR assumption that all planned
dividends and share repurchases would proceed during the two-year planning horizon,
regardless of how much stress the bank was under and, on the other, the concept of a
capital conservation buffer above minimum capital requirements as it has been added to the
capital rules. The second is a soft limitation on dividends put in place by the Board at the
inception of CCAR. Both of these features of CCAR reflected supervisory concerns with the
fact that, even as the financial crisis was clearly unfolding, some of the largest banks
continued to repurchase shares and pay dividends to shareholders and, thereby, depleted
capital that proved to be needed later.12
The SCB approach addresses the first of these issues by providing a continuous constraint
on any planned distributions that would bring capital levels below the sum of the minimum
4.5 percent of risk-weighted assets plus the firm-specific SCB, plus any applicable GSIB
surcharge.13 However, because declines in observed and reported capital levels usually
occur with a lag, and the historical evidence that dividends are less likely to be curtailed than
share repurchases,14 we would assume a firm will maintain its dividends for one year while
reducing its repurchases. This would have the effect of requiring a firm to hold capital to meet
its stress losses and fund its planned dividends over the next year.
The switch to an SCB approach would also give us an opportunity to address a second
issue, the soft limit on dividends in CCAR. Since its inception, our policy statements on
CCAR have indicated that a capital plan with a planned dividend payout ratio above
30 percent would be subjected to particularly close scrutiny. When this policy was adopted in
late 2010, we expected that it would be a useful guideline during a period when most of the
CCAR banks would need to continue increasing capital levels for some time but also
recognized that at some point we would need to revisit it.
Since the new approach of adding one year's planned dividends to a firm's capital buffer
should act as a disincentive for imprudent or unsustainable levels of dividends, the notion of
extra scrutiny on planned dividends may no longer be useful. And we would, in any case, be
reluctant to substitute a higher payout ratio for the original 30 percent ratio because it may
end up being an implicit target for banks to try to reach. However, firms planning higher
dividends should be aware that the operation of the SCB is such that, if a firm planned to pay
out all of its earnings in the form of dividends and things did not go as well as expected for
the firm, it could end up having to cut its dividend.
Balance sheet and risk-weighted asset assumptions
Beyond requiring that large banks have the resiliency to weather a period of serious financial
stress, an important macroprudential aim of stress testing is to ensure that they can provide
credit to households and businesses that remain creditworthy even in such a period. If banks
maintain their capital ratios under stress by reducing their balance sheets through asset
sales, or reductions in new lending, this crucial intermediation function will be compromised
across the economy. The result could be a credit crunch, likely resulting in a more severe or
longer-lasting recession. In the first few years of CCAR, we used the banks' own projections
where many banks planned on balance sheet declines as part of their strategy for remaining
sufficiently capitalized.15 In the 2014 CCAR cycle, we replaced banks' projections with our
own model, adding a requirement that banks would not restrict the supply of loans during the
severely adverse scenario.
To date, the model has actually operated to project an increase in the balance sheets of the
CCAR banks during the severely adverse scenario, with varying impacts on different
portfolios. This assumption, and its somewhat complicated implementation, was designed to
be fairly conservative, in a manner not dissimilar to the assumptions about capital
distributions. Numerous banks have attempted to show why some of these portfolios or
business lines would not be increasing under any reasonable assumptions, and thus that
even macroprudential goals do not justify ignoring the likelihood that those portfolios would
decline. During our review of CCAR, some banks proposed ways to distinguish among
business lines so as to relax what they argued to be an unrealistic assumption, even one
with a macroprudential purpose.
The complexities of trying to differentiate across idiosyncratic business lines seem to us
considerable. We are instead considering replacing this feature of our model with a simple
assumption that balance sheets and risk-weighted assets remain constant over the severely
adverse scenario horizon. Given that some decline in demand by creditworthy borrowers for
loans is inevitable in a serious recession, this simpler assumption would still achieve the
macroprudential policy objective that any such decline in lending during a recession is
attributable to the impact of the recession, rather than to capital constraints at the large
banks. This change would also make the treatment of balance sheets and risk-weighted
assets simpler and more transparent.
Toward a more macroprudential stress testing regime
The second major objective in our stress testing review was to integrate more
macroprudential elements into the program. Of course, combining the GSIB surcharge with
the SCB approach promotes an important macroprudential aim, since the surcharges are
calibrated to force large, interconnected banks to internalize the additional costs their
distress would impose on the financial system. The surcharges are thus at least a partial
surrogate for inclusion of various macroprudential features in the stress test.
We are also considering a couple of relatively modest revisions we are considering to the
Board's "Policy Statement on the Scenario Design Framework for Stress Testing"16 that are
motivated by the macroprudential consideration of reducing procyclicality. The first would be
to make the severity of the change in the unemployment rate less severe during downturns.
The second would be to replace the current judgmental approach to setting the hypothesized
path of house prices by tying this variable to disposable personal income. The result would
be a more countercyclical path of house prices and increased transparency into how we
determine the severity of this very important element of the scenario.
Beyond these steps, we heard many ideas during our review on how we might pursue our
macroprudential objective by adding new features to the stress test, especially from official
sector representatives and academics. We also reviewed the growing academic literature on
this topic. We concluded that, to this point, even the most conceptually promising of the ideas
are a good ways from being realized in specific and well-supported elements of our
economic models. Many macroprudential risks involve the spread of stress from one firm or
market to others. As such, macroprudential elements of stress tests often must estimate not
just first-round losses, but also the knock-on effects, which depend significantly on the
vulnerabilities and responses of all other major actors in the financial system, including many
that we do not regulate. Modelling these effects requires information about the behavior of
those actors that may not be observable either to a firm or to us.
Notwithstanding these and other practical challenges, many of the suggestions we received
have focused on important potential risks that bear further inquiry by regulators. Hence we
will be undertaking a research program to pursue these ideas in order to better understand
the quantitative consequences of new risks and business activities, potential amplifica