CCAR changes spell supervision shift

Is the Fed’s approach to capital inspired by the tailoring trade?

The Federal Reserve is upgrading its 2016 stress test for large financial institutions to include the Basel Committee's principles on risk-data aggregation and reporting.

Counsel in the US see it as a sign that capital requirements are evolving along the lines of an increasingly discretionary and bespoke approach.

The Comprehensive Capital Analysis and Review (CCAR) is an annual exercise, and the Fed's method for assessing whether the largest US banks have enough capital to operate during imagined economic and financial stress. The Fed also tests the banks for forward-looking capital planning that takes account of their individual risks.

The Basel principles on risk-data aggregation and reporting, known as BCBS 239, require banks to report aggregate risk data to regulators and senior management promptly. The principles were designed to be applied to globally systemically important banks (G-Sibs) and carried a compliance deadline of January 1 2016. Significantly, 14 G-Sibs had previously indicated that they would not be in compliance by that deadline.

In 2016, CCAR will include 33 bank holding companies with $50 billion or more in total consolidated assets.

The stress test scenarios are threefold: baseline, adverse and severely adverse economic circumstances. The Fed's deadline for CCAR submissions was Tuesday April 5. Given the latest developments, counsel see a backward jump.

"We are returning to the early days of Fed capital supervision, when capital was wholly discretionary. It was called Leavittation after Brenton Leavitt who was head of Fed supervision," said Oliver Ireland, partner at Morrison & Foerster. "That means that capital requirements are what the Fed says they are."

The Fed is not passively adopting principles without input. In fact, it's a major participant in Basel Committee's deliberations. "I would expect them to adopt their own versions of policies adopted by the BCBS," said Ireland.

As such, the Fed can adapt Basel ideas to US market requirements. The Fed certainly has a lot of discretion with CCAR itself, which plays a major role in shaping US bank capital requirements. But looking at the currently anaemic US recovery, counsel are wondering how much capital the Fed will eventually think is enough.

"At what point do capital requirements become an impediment to economic growth?" queried Ireland. He said US policymakers should consider an interesting dilemma: whether regulatory suppression of the US economy will, in the long-run, cost more than the crises capital requirements seek to avoid.

"One has to wonder about the role that capital and other supervisory requirements are playing in the slow recovery," said Ireland.

Of course if capital requirements are hampering the US economy, regulators would argue that's a small price to pay compared to the fallout from another large-scale banking crisis. But counsel are also sceptical as to whether the upside to higher capital requirements – protecting the US economy from crises – is realistic.

"CCAR is about more capital but there's no plan that will result in orderly liquidation in the worst case scenario. The government will have to step in," said V Gerard Comizio, partner at Paul Hastings. "You can always quibble about where to place the deck chairs on the Titanic."

"That doesn't mean that if all hell breaks loose, such institutions will be able to sell a division into an illiquid market," he added.

The Fed's decision is part of an overall evolution in bank capital requirements, starting with Basel I which focussed on quantitative capital regulation and used generic measures of risk.

Basel II was adapted for better economic conditions and large financial firms were offered an internal ratings-based (IRB) approach to customise their risk weightings. After 2007-2009, Basel III understandably marked a turnaround from Basel II, featuring higher capital requirements.

"It's the government deciding risk weights and that's a reaction to the final crisis. The tailoring of capital requirements is taking a sharp turn from Basel II," said Comizio.

Counsel consider Basel III, and in particular its capital conservation buffers, as redolent of another theme in the evolution of capital requirements: a bespoke approach to capital.

"We're in the haberdasher era of capital with capital conservation buffers. The Fed can take a look at a bank, like a tailor, and say: 'you're about a size 40 and so we'll cut your suit like this'," said Comizio.

For Comizio, that's the key to understanding any future Basel IV. "Basel IV, if it were adopted in better economic times, might be an effort by industry to push back on the capital conservation buffer because it has a lead in time of 2018."

And that would be a far easier argument for banks to make in an up market. "I can see industry saying; 'wait, we need more capital in good times? We need that for the economy'," said Comizio.