WASHINGTON — The Federal Reserve will use the outcome of a supplemental test of large banks' pandemic response to help determine whether financial institutions can make planned capital distributions, a top Fed official said Friday. However, test results for individual banks will not be disclosed publicly.
Fed Vice Chairman for Supervision Randal Quarles detailed the process of conducting so-called sensitivity analyses, which are being added to the standard annual stress tests given to the largest banks to assess the strength of their balance sheets in the current economic downturn and various recovery scenarios.
He explained that the analyses will work effectively as a modified stress tests that factor in three different scenarios for an economic recovery following the COVID-19 outbreak.
The assessments will adjust the unemployment rate, gross domestic product and Treasury rates based on three scenarios: a V-shaped economic recovery, a U-shaped recovery and a W-shaped recovery. The last implies a second round of social distancing and business closures.
The central bank added the sensitivity analyses in part because the standard cycle of stress tests this year — the results of which will be released next week — do not incorporate the dramatic economic impact of the pandemic.
“Although we didn’t run our full stress test on these three possible downside risk paths for the economy, and while our adjustments only capture the most material changes in balance sheets since last year, this sensitivity analysis has helped sharpen our understanding of how banks may fare in the wide range of possible outcomes,” Quarles said at a virtual event with the group Women in Housing and Finance.
The sensitivity analyses will be used in part to inform the Fed's decision about a firm’s dividend plans, Quarles said.
“The sensitivity analysis will help us judge whether banks would have enough capital if economic and financial conditions were to worsen,” he said.
In a Q&A after his speech, Quarles was asked about the potential of the Fed imposing a blanket ban on dividends. But he appeared uneasy about the prospect of overhauling the stress test regime too drastically and disrupting how the Fed has treated capital distributions in the past.
“We have had a shock of a nature and severity that is unprecedented … and I think that does justify a close analysis of what the potential risks to the system are,” he said. “On the other hand, I do think that it is important not to ignore the framework that has been developed.”
Indeed, even though the Fed developed the sensitivity analyses in response to the pandemic, the central bank has made clear that it has conducted this year’s regular stress tests the same as previous cycles.
“The question is, do you simply toss out that elaborate framework on the basis of which many market participants have made investment decisions?” Quarles said. “Or do you conduct, as is contemplated by that framework, a very careful stress test with sensitivity analyses that are designed to take account of the current uncertainty, and then come up with an analytic and granular basis for any additional actions that you might take?”
However, it may be difficult for the public to assess how individual banks perform across the different coronavirus-related scenarios. Although the Fed will be testing each firm against the supplemental scenarios, the published results will show a composite of the 34 banks tested.
“We will provide key details about the three downside risk paths for the economy and targeted adjustments,” said Quarles. “We will also provide results aggregated across banks that will compare how the banking system as a whole would fare under the three distinct views of the future.”
However, the Fed will not be using the most recent bank data to run its sensitivity analyses, Quarles said, largely because the agency didn’t have enough time to run the tests based on more recent data.
Instead, it will use bank data from the end of 2019 — before the onset of the coronavirus — but will change some elements of the fourth-quarter data in order to more closely resemble the current financial position of the industry.
“The analysis is still based on year-end 2019 data, but with targeted adjustments to account for the most material changes to banks’ balance sheets in the first quarter related to the COVID event, such as sizable credit-line drawdowns by corporations,” said Quarles.
The Fed also will attempt to account for “substantial growth in corporate loan borrowers” as well as “stress on borrowers” in certain sectors that have been acutely impacted by the pandemic.
The sensitivity analyses will not be used to determine a firm’s capital requirements for the year. Rather, banks will have to comply with a stress capital buffer requirement based on the Fed’s original stress tests, because the Fed did not want to require banks to hold thicker layers of capital in the midst of a downturn.
“We kept in mind the principle that if possible we should avoid measures that tighten minimum capital levels during a crisis, to avoid intensifying that crisis,” said Quarles. “Should our assessment of the COVID event’s likely evolution change, of course, we will act expeditiously to resize the buffer or take other appropriate actions.”
The Fed
Banks will be able to make changes to their capital plans after next week’s results are published, and then the Fed will release the final capital plans before the stress capital buffer requirement is set to take effect in the fourth quarter.
Quarles provided more information on the stress capital buffers after his prepared remarks, noting that banks will be provided with “indicative” stress capital buffers after the results of next week’s stress tests are made public. Banks will then be able to challenge their buffer “if there are clear issues with the calculations.”
On June 25, the Fed will release the aggregate results of the sensitivity analyses along with the results of both its annual Dodd-Frank Act and CCAR stress tests.
