Client Alert

Federal Reserve Board Establishes Stress Capital Buffer for Large Banks

12 Mar 2020

On March 4, 2020, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) approved a final rule amending several of the Federal Reserve’s regulations and policies (and making associated changes to regulatory reports) for bank holding companies (“BHCs”) and U.S. intermediate holding companies of foreign banking organizations, in each case with $100 billion or more in total consolidated assets (the “Final Rule”).[1] The Final Rule replaces the static 2.5% component of a firm’s capital conservation buffer requirement by integrating the capital rule with the Comprehensive Capital Analysis and Review (“CCAR”), as implemented through the capital plan rule. This is accomplished by using the results of supervisory stress tests to establish a firm’s stress capital buffer (“SCB”) requirement and establish a unified approach to capital distribution limitations.

The Final Rule will be effective 60 days after publication in the Federal Register, with a bank’s first SCB requirement effective October 1, 2020.[2]

Background

Following the 2008 financial crisis, the federal banking agencies imposed enhanced minimum risk-based and leverage capital requirements upon banking institutions consistent with the Basel III capital framework to improve their resiliency in absorbing unanticipated losses and asset value declines. These included a minimum common equity tier 1 (“CET1”) risk-based capital requirement and a fixed capital conservation buffer equal to 2.5% of risk-weighted assets. Over the past ten years, stress testing and strong risk-based and leverage capital requirements have become critical features of the Federal Reserve’s supervision program for large banking organizations. Large banking organizations also became subject to a countercyclical capital buffer requirement, and global systemically important BHCs (“GSIBs”) became subject to an additional capital buffer based on their systemic risk (the “GSIB surcharge”). Separately, the capital plan rule was implemented, requiring large firms to maintain capital plans based on individual capital adequacy assessments. This stress test-based capital requirement projects a firm’s capital needs under adverse economic conditions.

In April 2018, the Federal Reserve issued a proposal to simplify its capital framework by (1) integrating ongoing non-stress and stress test-based capital requirements through the establishment of an SCB requirement, and (2) reducing the number of capital requirements applicable to these large firms from thirteen to eight (the “Proposed Rule”). The Final Rule largely tracks the Proposed Rule, with some differences noted below.

The SCB Requirement

Under the Final Rule, the Federal Reserve will use supervisory stress test results to establish the size of a firm’s SCB requirement. The SCB requirement is subject to a floor of 2.5% of risk-weighted assets under the Final Rule, and is calculated as: (1) the difference between the firm’s starting and minimum projected CET1 capital ratios under conditions akin to a severe global recession, plus (2) four quarters of planned common stock dividends as a percentage of risk-weighted assets. This calculation assumes four quarters of planned common stock dividends, modifying the CCAR assumption that a firm would make nine quarters of planned capital distributions under stress.

Furthermore, the CCAR assumption of a growing balance sheet over the nine-quarter planning horizon is replaced in the Final Rule by an assumption of a constant balance sheet. The Final Rule also eliminates the 30% dividend payout ratio as a criterion for heightened scrutiny of a firm’s capital plan to encourage firms to increase payouts through additional share repurchases, rather than dividends.

The SCB requirement will supplement a firm’s risk-based capital requirements and replace the static capital conservation buffer requirement. It combines the results of supervisory stress tests (a CCAR element) with the Federal Reserve’s non-stress capital requirements, creating a single, risk-sensitive framework. A firm whose capital ratios fall below its buffer requirements will face automatic restrictions on its capital distributions.

In a change from the Proposed Rule, under the Final Rule, a material business plan change, such as one resulting from a merger or acquisition, would generally be excluded from the SCB requirement calculation. The impact of such a change will instead be reflected in a firm’s capital ratios once the change is consummated. However, the Federal Reserve may require a firm to resubmit its capital plan in the event of a material business change, and subsequently recalculate the firm’s SCB requirement. This approach is intended to limit the number of assumptions in the SCB requirement calculation, simplifies the framework, and reduces burden.

The Proposed Rule contained a stress leverage buffer requirement that would have been based on the supervisory stress test. Given that the Final Rule integrates CCAR with non-stress capital requirements that include leverage ratio requirements, the stress leverage buffer requirement was excluded from the Final Rule. Non-stress leverage ratio requirements, which are non-risk based, are maintained as effective backstops to risk-based capital requirements.

To address potential volatility caused by the SCB requirement and to prevent abrupt automatic distribution limitations as a firm’s capital ratios decline, the Final Rule revises the definition of “eligible retained income” in the non-stress capital requirements to a quarterly average net income measure (under certain conditions).

Under the Final Rule, unlike the Proposed Rule, firms in compliance with the capital framework’s automatic distribution limitations may generally (with exceptions) make capital distributions beyond the planned capital distributions included in its capital plan without prior Federal Reserve approval. These firms instead face automatic distribution limitations if their capital ratios drop below their buffer requirements. This change further unifies the capital framework’s limitations on capital distributions.

Conclusion

The Final Rule is the latest, and most significant, in a series of overhauls by the Federal Reserve, under the current administration, aimed at relaxing and simplifying regulatory requirements established under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Federal Reserve noted in the preamble to the Final Rule that it intends to propose further modifications to simplify and clarify the stress-testing framework.

Federal Reserve examiners review capital adequacy of large financial institutions on an annual basis, based upon an assessment of a firm’s expected sources and uses of capital during a nine-quarter planning horizon. Going forward, a determination will be made based upon (1) a reduced list of capital requirements, (2) the SCB requirement, and (3) any applicable enhanced supplementary leverage ratio imposed upon GSIBs. If a firm fails to satisfy these requirements, it would face limitations and restrictions on its ability to make capital distributions. In light of the Final Rule, firms should revisit capital plans to reevaluate the potential availability of capital to fund operations after giving due consideration to the SCB requirement.


[1] The Final Rule and additional related information are available here.

[2] The Final Rule has not yet been published in the Federal Register.

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