Randal K Quarles: Refining the Stress Capital Buffer
Speech by Mr Randal K Quarles, Vice Chair for Supervision of the Board of Governors of the
Federal Reserve System, at the Program on International Financial Systems Conference,
Frankfurt am Main, 5 September 2019.
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Introduction
Thanks to the Program on International Financial Systems and the European Central Bank for
the opportunity to speak to you today. I would like to take as my text today this reflection of the
20th-century philosopher, sociologist, and welterweight champion of the world, Oscar de la Hoya:
"There's always room for improvement, no matter how long you've been in the business." As all
of you know, 2019 marks the 10-year anniversary of our stress testing program in the United
States. In only 10 years, stress tests have developed from an innovative but untested tool to
become a well-established element of the Federal Reserve's bank supervision program for large
banks. But developing and running those first tests required a willingess to change, and an
openness to innovation, which underly every advance in human endeavor-whether banking or
boxing. In that same spirit of being open to change and innovation, my remarks will include some
thoughts that might have seemed novel just a few years ago, but in my view, are ideas whose
time has now come.
As the Federal Reserve has been considering refinements to our stress testing and capital
frameworks, two goals have been at the forefront of our thinking: first, to simplify these
frameworks to make them easier to apply and understand, and second, to maintain the overall
high level of loss-absorbing capacity in the banking system. Let me expand on those two goals.
Goals for Refining Stress Testing and Capital Frameworks
One of the great challenges of a regulator is to write rules that are comprehensive and detailed
enough to be effective while also being consistent and simple enough to be well understood.
There is a well-documented tendency for regulation to grow by accretion. And with that, there is
always a risk that regulatory regimes will become less effective as they grow, developing
redundancies and inconsistences that can obscure initial intentions and impair understanding.
This is not a desirable outcome for financial regulation, and indeed, it is the responsibility of any
regulator to ensure that the rule frameworks remain well integrated and credible.
Congress has been adjusting the Dodd-Frank Act since its enactment, and, likewise, the Federal
Reserve and other regulators have been making adjustments in the wake of the financial crisis to
innovations such as stress testing, a public process that in my view has helped make financial
oversight more effective. The thoughts that I am airing in these remarks, part of a public process
of discussion and debate, should be seen as a continuation of the review and adjustment that
has been taking place since the financial crisis. The goal is to simplify rules that have grown
more complex in the past decade and in some cases redundant and harder to understand.
My second goal, in considering these adjustments, is to maintain the high level of loss-absorbing
capacity in the U.S. banking system. Our financial system today is far more resilient than it was
before the crisis and I want to maintain that resiliency. We are all better served by
wellcapitalized banks that have the ability to continue lending to households and businesses even
during stressful times. Adjusting regulation in measured ways, such as those I will describe, is
an appropriate and, in fact, necessary way to preserve the success we have achieved in
strengthening the financial system.
Before I delve into describing the future direction of our stress testing and capital frameworks,
allow me to begin with some background on the origins of the stress testing program and an
overview of the changes we have made to our capital requirements since the financial crisis.
Background on the Fed's Stress Testing Program
At the height of the crisis, as a way to help restore confidence in the largest U.S. banks, the Fed
created the Supervisory Capital Assessment Program (SCAP) to estimate potential losses at
those banks, if economic and financial conditions worsened. Building on the success of SCAP,
the Board moved to the current stress testing assessment, known as the Comprehensive
Capital Analysis and Review (CCAR), to evaluate whether the largest firms have sufficient capital
to continue to lend and absorb potential losses under severely adverse conditions.
At the same time that we were building our stress testing program, we were also making
changes to capital rules to address weaknesses observed during the crisis. These included new
minimum capital requirements and a capital buffer on top of these requirements. The buffer puts
increasingly strict and automatic limits on capital distributions as a bank's capital declines toward
the minimum. Large banks are also subject to a potential countercyclical capital buffer (CCyB),
which I will discuss more shortly. And the largest banks are subject to an additional buffer of
capital based on a measure of their systemic risk.
Stress testing and stronger capital requirements have combined to greatly strengthen the
resiliency of the U.S. banking system. At the banks subject to CCAR, risk-based capital ratios
have more than doubled since 2009. Combined, these firms now have more than $1 trillion of
common equity capital, and a ratio of common equity to risk-weighted assets of 12.1%, which is
many multiples over the required ratio of Tier 1 common in 2009. As a result of these changes,
large U.S. banks are substantially more resilient to stress than in the past.
At the same time, I believe our regulatory measures are most effective when they are as simple
and transparent as possible, and it is prudent to periodically review all of our practices to ensure
that they are achieving these goals. Importantly, although CCAR and our regulatory capital
requirements share similar ends, they were developed separately, due to the exigencies of the
crisis, and this has led to significant redundancies, which I will describe in detail in a moment.
Just to name one prominent example, we now have 24 different requirements for total loss
absorbency, while before the financial crisis we had 3. Perhaps there were some benefits to
having overlapping approaches when we were still in the capital-building phase after the crisis.
But now that banks have built significant capital stores, I believe the overlapping requirements
should be combined for efficiency and simplicity.
The Stress Capital Buffer (SCB) Proposal
Last year, the Board issued a proposal to address these redundancies. The proposal-known as
the stress capital buffer-would simplify our regulatory regime by integrating the stress test with
our non-stress capital rules. I believe the SCB proposal stands as a good example of how our
work can be done more efficiently and effectively, and in a way that maintains the resiliency of the
financial system.
For large bank holding companies, the SCB would replace the
fixed-for-all-times-and-for-allbanks 2.5 percent risk-based capital buffer with a firm-specific buffer based on the firm's most
recent stress test results. This would integrate our stress testing capital requirements with our
point-in-time capital requirements. And as a result, the two separate capital frameworks would be
combined into one. Firms would have to manage according to one integrated set of requirements
and, when their capital is insufficient, would be required to rebuild their resiliency through one
integrated set of limitations on their capital distributions.
Originally, we had planned to make the SCB final for the 2019 stress test cycle. However, we
received thorough and insightful feedback on the proposal that we have been considering
carefully. Among the comments we received were many that called for further simplification of
the SCB framework. Based on this feedback, I first would like to emphasize two elements of the
2018 SCB proposal that, in my more considered judgment, I now believe should not be a part of
the final SCB framework. Second, I would like to introduce two new co-equal options, either of
which would improve the final product.
The first element of the SCB proposal that I believe should be removed is the stress leverage
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buffer requirement. By its nature, a leverage ratio is a blunt instrument that treats all assets the
same and therefore is not risk-sensitive. Thus, I am concerned that explicitly assigning a
stressed leverage requirement to a firm on the basis of risk-sensitive post-stress estimates is in
conflict with the intellectual underpinnings of the leverage ratio. It is what the analytical
philosophers call a category mistake: like saying that, "Freedom has curly hair". Of course,
leverage ratios, including the enhanced supplementary leverage requirements, would remain a
critical part of our regulatory capital regime, and I believe our existing leverage ratios provide a
sufficient backstop to the risk-based capital requirements. For these reasons, it seems out of
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place and unnecessary to add a separate leverage capital buffer.
The second element of the SCB proposal that I believe should be removed 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 today 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. Additionally,
the SCB already has a mechanism for curbing dividends and other distributions when a bank's
capital ratio falls into the buffer. Requiring pre-funding of dividends is a needless redundancy.
Even worse, the pre-funding of dividends could lead to a conflict with the mechanics of the SCB
-the SCB could call for a restriction of dividend payments even when those payments had been
pre-funded. I believe it is better to focus on the root cause of our concerns and take a
comprehensive approach to ensuring that banks have sufficient capital, rather than focus on the
individual elements of capital distributions.
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Some have argued that requiring pre-funding of dividends helps reduce pro-cyclicality. Limiting
pro-cyclicality, or being countercyclical, essentially means limiting both the highs and lows of a
business cycle. And there can be value in doing so because, among other things, it can help
reduce stress on our financial system. With a counter-cyclical stress test, as the economy
strengthens, the test should get tougher and be more stringent to mitigate the buildup of
vulnerabilities during good times. Experience has shown that vulnerabilities can build during good
times as risk appetite grows and memories of earlier instability fade. But likewise, when the
economy does slow down, and losses mount at the banks, the tests should moderate so that
firms can draw on the buffers built up during good times to absorb those losses while continuing
to provide credit to qualified borrowers.
As an alternative to requiring pre-funding dividends and in furtherance of the other goals I have
mentioned, I would like to suggest two co-equal options that, in my opinion, would simplify our
capital requirements while limiting pro-cyclicality. Importantly, these two options also are
consistent with our goal of maintaining overall levels of capital in the banking system: The first
option would be to set the CCyB at a higher baseline level during normal times. And the second
option would be to raise the "floor," or the minimum level, of the SCB.
The CCyB Option
Before I outline how we might modify the CCyB, let me explain what the CCyB is designed to
accomplish and how it fits into the Board's overall financial stability efforts. The CCyB, which was
part of the original Basel III accord, is a macroprudential tool that allows the Board to dynamically
adjust capital levels of large banking firms when the risks to financial stability have meaningfully
changed. In 2016, the Board released a policy statement detailing the conceptual framework it
would follow to set the CCyB. The policy statement details the range of financial-system
vulnerabilities and other factors the Board may take into account as it evaluates settings for the
buffer, including but not limited to, leverage in the financial sector, leverage in the nonfinancial
sector, maturity and liquidity transformation in the financial sector, and asset valuation pressures.
Right now, our policy is to maintain a 0 percent CCyB when vulnerabilities are within the normal
range, as they happen to be now.
When we determine that vulnerabilities have risen to be meaningfully above normal, the purpose
of the CCyB is to increase capital to a level that compensates for those other rising vulnearbilities
and thus reduces risks back to a normal level. Some of those vulnerabilities have indeed been
rising in recent years, but because of the strength of our capital requirements and CCAR, our
assessment of overall vulnerabilities remains moderate. This raises the question of whether our
through-the-cycle capital levels in the United States have been set so high, that our CCyB is
effectively already "on": we already have capital at a level that compensates for these increases
in vulnerability, but because we did not reach that capital level through activiation of the CCyB,
we have no way of acting countercyclically in a future downturn.
I would advocate for revisiting that policy so that the CCyB is more closely integrated into our
overall capital framework, allowing greater scope for dynamic adjustments. While the Board has
maintained the CCyB at zero since 2016, other countries have adjusted their countercyclical
buffers in response to vulnerabilities within their financial sectors or, in the case of the United
Kingdom, to integrate its CCyB with its structural capital requirements. For example, I find the
U.K. framework, adopted by their Financial Policy Committee, to be quite compelling.
Specifically, under the British framework, the CCyB would equal a positive amount-in the British
case it's 1 percent-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.
I see real merit in application of the U.K. approach in the United States, although the specific
percentage would of course be open to analysis. It could provide a flexible mechanism that could
complement other modifications to the SCB framework and allow the Board to adjust capital
requirements as financial risks are evolving. In addition, making greater use of a countercyclical
capital buffer would quite directly advance the goal of making the overall capital regime less
procyclical.
Ultimately, I would expect that the new baseline for the CCyB would be set at a level that would
maintain the overall level of capital in the U.S. banking system throughout the business and
financial cycles-that is, taking account of the likelihood that there would be periods where it
would be above the baseline as well as below the baseline. To be clear, this shift would require
us to revisit our current CCyB policy and would introduce additional layers of decisionmaking
complexity to the SCB proposal. On balance, however, I think this kind of shift would provide the
Board with a helpful, additional tool that could be adjusted quickly in response to economic,
financial, or even geopolitical shocks.
I'd also like to preemptively address a potential objection to this option. That is, that it may be a
"stealth" cut to our strong capital levels for the largest banks. I reject that characterization, and it
is not supported by the approach I have outlined today. As I've said, we would maintain our strong
current loss-absorbency levels, and, though I have focused on the ability to reduce the CCyB in
times of stress, I also would stand ready to increase the CCyB above the new baseline when it
was appropriate to do so. Indeed, the advantage of a truly flexible capital requirement is for it not
only to provide additional resilience during a boom, but also to limit the risk of a pullback in credit
supply aggravating an economic downturn.
The SCB Floor Option
Returning to our goals of increasing simplicity, mitigating pro-cyclicality, and maintaining the
overall level of loss-absorbency in the system, I would like to advance another equally viable
alternative to turning on the CCyB: raising the proposed SCB floor from the fixed 2.5 percent of
risk-weighted assets to a somewhat higher level-purely for the sake of illustration, let's say 3
percent. Using 3 percent as an example, we would give each firm a buffer based on the firm's
most recent stress test results, but which must be at least 3 percent. For example, if a firm had
a capital ratio decline of 2.7 percent during the stress tests, its SCB would nonetheless be sized
at 3 percent, rather than 2.7 percent.
For firms that have stress test results indicating an SCB greater than 3 percent, this change
would have no impact compared to last year's proposal. For firms that have stress test results
indicating an SCB at or slightly above 2.5 percent, this change would represent a modest
increase in the stringency of the SCB.
Raising the floor may help to reduce pro-cyclicality by limiting the reduction in SCB capital buffers
when stress test losses decrease during good times. Raising the floor also would help moderate
any increase in those buffers at the onset of economic downturn conditions as losses begin to
increase. This approach would have three significant benefits as compared to the CCyB option:
greater simplicity, transparency, and predictability. Raising the fixed floor would be simpler to
execute than the CCyB proposal because raising the floor once and for all times would not
require the Board to make complex, real-time decisions about how to adapt the regulatory
framework to the evolving vulnerabilities to the economy. Raising the fixed floor also would be
more transparent and predictable for the public and the industry because a firm's capital
requirement would vary less over time.
There are drawbacks to the higher fixed floor option, of course. For firms whose losses are
typically close to the existing 2.5 percent floor, this change will affect them more than others and
produce a capital regime with slightly less risk sensitivity. I also recognize, in terms of targeting
pro-cyclicality, this approach would be much less direct than more actively managing the level of
the CCyB.
Conclusion
In closing, let me say that it is my hope to have an SCB framework in place for the 2020 stress
tests. Of course, we will solicit public comment on potential revisions to the SCB proposal
through the standard rulemaking process, and I expect that to occur in the near future. I further
expect that we will maintain the basic framework of the SCB while also incorporating some
additional refinements, such as to address volatility and provide better notice for firms in planning
their capital actions.
As I have stated, our goals remain to simplify our capital framework while maintaining the overall
amount of capital in the U.S. banking system. The refinements we are considering to the SCB
framework would also improve the efficiency, coherence, and transparency of the regulatory
capital framework and the core principles of our stress testing program that have proven
successful. I look forward to continued feedback on CCAR as we work through the
improvements that I described, with a goal of ensuring that we maintain the same incentives for
effective stress testing practices that exist today. As I am sure Oscar would agree, there is
always room for improvement in the stress testing ring.123