WASHINGTON — The U.K.'s surprise vote last week to leave the European Union has upped the ante for the banks taking part in the Federal Reserve Board's second round of stress tests on Wednesday.
The one bright spot following last week's abrupt turn of events was the positive scores the banks received on the initial round of Dodd-Frank stress tests. But those are effectively the warm-up round compared to the release this week of the Comprehensive Capital Analysis and Review, which takes into account each bank's capital plan amid a hypothetical severe economic downturn.
That theoretical scenario now appears less far-fetched.
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The industry is better positioned than it was last year to weather a severe economic shock, according to the Fed, but the real test comes next week, when the central bank will release its latest evaluation of the sector's risk-management practices.
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Federal Reserve Govs. Jerome Powell and Daniel Tarullo Thursday said they expect banks to have to meet significantly higher capital minimums after the central bank applies its capital surcharge rule for large globally risky banks to its stress test. That difference could significantly cost banks.
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The Federal Reserve is looking for advice and insight into how it might improve its annual stress testing regime, but banks and industry observers say the central bank is unlikely to touch the aspect of the tests that bothers them most: its secrecy.
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After the United Kingdom's surprising vote to exit the European Union, the financial markets are in turmoil and U.S. banks are left trying to assess their risks.
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"Events like Brexit are why the Fed draws up an 'adverse scenario' and a 'severely adverse scenario' for its stress tests," Ian Katz, an analyst Capital Alpha Partners, wrote in a note to clients.
To be sure, CCAR's scenarios do not include the effect of the so-called Brexit, and the results of the tests were likely tallied well before the vote. Yet the event will also provide some perspective for the Fed in determining exactly what sort of scenario it should be measuring.
"If those factors that are being modeled out are insufficient to capture Brexit, then we need to go back and revisit the stress test itself," said Ed Groshans, an analyst at Height Securities.
Wayne Abernathy, executive vice president at the American Bankers Association, said the U.K. referendum to leave the EU has not triggered the Fed's extreme scenarios, but so far it is just a "two-day event."
"What the stress test is designed to do is more of a longer-term trend than a snap event, and that is appropriate because given the liquidity that banks put in and all the precautions they put in place, they are really well prepared for these surprise events that may happen," Abernathy said. "What is more important is things that last over periods of weeks or months and that is part of the value of the whole stress test — it is forward-looking."
This year's CCAR test comes as the Fed weighs significant changes to it, such as including a capital surcharge to the largest banks while easing up on some other requirements.
"It is likely, I believe, that we will incorporate the full amount of the surcharges into the post-stress capital requirements," Fed Gov. Jerome Powell said earlier this month. "It will be a substantial increase in the requirements, but there will be some offsets."
Greg Baer, president of The Clearing House, said in testifying before a Senate panel last week that the Fed could begin with less-extreme economic assumptions.
"There are examples where under CCAR the assumption around unemployment is extremely severe which necessarily puts pressure on loans that are subject to greater default rates if in fact unemployment rises which are basically loans to folks who do not have significant wealth or steady income," Baer said.
Fed Chair Janet Yellen also told lawmakers during her semiannual testimony on monetary policy that the tests could be less stringent for the large regional banks.
"We want to tailor our regulations so that they are appropriate to the risks. And we are likely to make changes to the stress testing regime that would reduce burden on some of the smaller banking organizations that are subject to — to that process," Yellen said before the Senate Banking Committee.
She added that it is "very likely" that banks with assets of $50 billion to $250 billion would be exempted from the qualitative portions of the CCAR stress test, an idea first floated by Fed Gov. Daniel Tarullo.
"The full qualitative part of CCAR that relates to capital planning … they might be exempted from that," Yellen said.
But Groshans said the Brexit could cause the Fed to act carefully as it makes adjustment to the tests. "Because [Brexit] happened at the same time as the stress test, I think the Fed will move very cautiously in how they would loosen up the standards for the regional banks," he said.
Abernathy also advocated for a more transparent process with public input for some of the assumptions.
"The Fed is very familiar with the [advance notice of proposed rulemaking] process and that might be a good format for that, because that doesn't tie them down but creates a venue for them to receive a lot of input and a lot of input on the record," Abernathy said.
However, Yellen said in testimony last week that subjecting the stress test scenarios to public comment could limit the Fed's ability to construct productive tests.
"It's very important that the scenarios be current and reflect risks that we assess to be important and relevant at a particular time that we're conducting those stress tests, and the delay that would be caused by putting out for comment in particular scenarios would result in the test being stale," Yellen said before the House Financial Services Committee.
But Abernathy said the compressed time frame puts pressure on the Fed to quickly turn around the stress test results, which can lead to knee-jerk market reactions. "The stress test should not be this annual surprise to the markets and the financial institutions," he said.
