Fed’s Proposed Amendments to Capital Plan & Stress Test Rules

On July 17th, the Federal Reserve Board (“Fed”) issued a proposed rule that provides some relief from capital stress testing requirements. [1] Most notably, it eliminates advanced approaches risk-weighted assets and tier 1 common capital (“T1C”) calculations from stress testing, and provides a one year delay in the application of the supplementary leverage ratio (“SLR”) to stress testing. The proposal also does not incorporate the G-SIB surcharge into stress testing at this stage—see PwC’s First take: Key points from the Fed’s final G-SIB surcharge rule (July 22, 2015)—and makes clear that no additional changes will be applied to next year’s stress testing cycle.

1. Advanced Approaches RWA calculations remain excluded from stress testing. Advanced Approaches RWA (“AA RWA”) is very unlikely to ever be included in stress testing projections, as the Fed has delayed their introduction “until further notice.” This is great news for those large Bank Holding Companies (“BHCs”) that have exited, or are in the process of exiting, parallel run. Including AA RWA calculations into stress testing projections would have been a significant burden for BHCs [2] and a likely problem for the Fed which would have had to develop AA RWA models (on top of its many other stress testing models) with potentially limited supervisory benefit. The continued exclusion of AA RWA from stress testing is the latest step in the Fed’s and the Basel Committee’s efforts to limit the importance of BHC models to capital adequacy assessments. [3]
2. Bye-bye Basel I—T1C is eliminated from stress testing. BHCs will no longer report T1C or be subject to the T1C 5% minimum threshold as part of stress testing. [4] This change is a reporting and systems benefit to all firms, as they now have the option to turn off their Basel I capital deduction machinery. [5] The rationale for this change is that common equity tier 1 (“CET1”) is already more binding (despite its lower 4.5% minimum threshold) or will become more binding as the phase-in of Basel III in the US is completed. [6]
3. The SLR will not be incorporated into stress testing until 2017. Rather than force advanced approaches BHCs to build their stress testing SLR capabilities over the next 6 to 8 months in advance of the new April 5th submission deadline, the Fed has decided to follow the implementation schedule as it existed before last October’s change from January to April submissions (i.e., SLR inclusion still will not start until the 2017 cycle). [7] This was a source of uncertainty, but BHCs can now focus their near-term energies on enhancements and remediating any outstanding issues in preparation for 2016. Advanced approaches BHCs should, however, continue to consider both their internal processes for projecting the SLR and developing capital plan policies that will keep the SLR above the 3% minimum threshold under the Fed’s severely adverse scenario (and must of course continue to meet the tier 1 leverage ratio minimum of 4%).
4. Calendar delays for savings and loan holding companies. The Fed clarified that savings and loan holding companies (“SLHCs”) with more than $10 billion in assets will not be subject to firm-run stress testing until the 2017 cycle. This resolves the concern of some SLHCs that Fed stress testing would have begun for them in 2016.
5. The proposal improves the coherence of stress testing rules, in the following ways:
   1. Permits BHCs and SLHCs with $10 to $50 billion in assets, which are only subject to firm-run stress tests under Dodd-Frank, to no longer follow the fixed-dividend assumption embedded in DFAST rules. [8] This will let them create more realistic capital distribution assumptions—e.g., around the “upstreaming” of dividends from their depository institutions under stress—which could boost their minimum post-stress capital ratios.
   2. Allows a BHC to include in its DFAST submission any planned capital issuances associated with planned acquisitions. The current DFAST rules cause an inconsistency between the right- and left-hand sides of the balance sheet because BHCs must assume the assets from an acquisition without assuming the associated capital issuance, while CCAR allows BHCs to assume both. This was a source of frustration for several BHCs in the 2015 cycle because the existing rule forces an artificial wedge between their CCAR and DFAST capital results and prevents their DFAST balance sheet from balancing.
   3. Seeks to make DFAST rules around dividend assumptions more coherent by allowing large BHCs to assume that they pay dividends on common stock issuance related to expensed employee compensation (following a change in October 2014 that allowed BHCs to assume such issuances in the first place). Currently, DFAST requires that dividends be constant over the planning horizon regardless of these new common stock issuances, which reduces a BHC’s dividends per share as the amount of stock increases.
   4. Applies the Volcker Rule’s definition of capital, which deducts aggregated investments in covered funds from tier 1 capital, to stress testing. [9] This does not come as a surprise, as it seemed self-evident and also promotes consistency across regulatory reporting.

Endnotes:

[1] In this First take, “stress testing” refers to both Comprehensive Capital Analysis and Review (“CCAR”) and Dodd-Frank Act Stress Testing (“DFAST”).
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[2] These banks must of course still calculate both standardized RWA and AA RWA to complete their quarterly FR Y-9C filings and to determine their capital adequacy outside of stress testing.
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[3] This global momentum away from models-based approaches accelerated when Fed Governor Daniel Tarullo indicated in May 2014 that Fed stress tests provide a better risk-sensitive basis for setting minimum capital requirements than do internal ratings-based approaches under the Basel II framework (as well as under Basel III’s AA RWA). See PwC’s Regulatory brief, Operational risk capital: Nowhere to hide (November 2014) (discussed on the Forum here), as an example of the application of this concept.
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[4] T1C became prominent as the Fed’s preferred capital measure during the Supervisory Capital Assessment Program in 2009 and, by design, was a more binding constraint than Basel I tier 1 capital (which was the standard at the time).
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[5] Although T1C was not itself a Basel I measure, it required calculating capital deductions on a Basel I basis. BHCs have already stopped reporting those Basel I deductions on their quarterly FR Y-9C filings.
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[6] See PwC’s Regulatory brief, Basel III capital rules finalized by Federal Reserve (July 2013).
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[7] Banks were concerned as the one-quarter delay to the stress testing calendar (that takes effect in 2016) pushes the 9-quarter planning horizon for 2016 into the first quarter of 2018—i.e., beyond the January 1, 2018, effective date for applying the SLR. See PwC’s First take, Ten key points from the 2015 CCAR guidance and final revised capital plan rule (October 2014).
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[8] See PwC’s First take: Ten key points from the Fed’s 2015 DFAST (March 2015) (discussed on the Forum here) which explains that DFAST, unlike CCAR, relies on banks’ most recent dividends to project distributions through the 9-quarter planning horizon.
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[9] See PwC’s First take: Ten key points from the Fed’s covered funds extension (December 2014).
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