The Comprehensive Capital Analysis and Review and the New Contingency of Bank Dividends

My recent paper explains why, from a bank supervisory perspective, the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) program is arguably the single most significant and innovative post-crisis regulatory reform. Established in 2011, the CCAR is an annual Federal Reserve exercise to evaluate the capital planning processes and capital adequacy of the largest bank holding companies and other financial institutions designated as systemically important by the Financial Stability Oversight Council.

In this blog post, I will highlight three observations concerning the CCAR program. First, I will explain the significant practical implications of the CCAR for large U.S.-domiciled banks. Second, I will discuss one important, distinctive feature of the CCAR program: namely, its reliance on discretionary judgments by regulators concerning a hypothetical, uncertain future. Third, I will describe why this feature makes the CCAR a “risk regulation” regime – a designation developed in the environmental, health, and safety (“EHS”) regulatory context that has been underappreciated, underutilized, and undertheorized in the financial regulatory context.

The first observation is the most straightforward and technical: by requiring bank holding companies to obtain approval from the Federal Reserve before distributing capital to their stockholders, the CCAR makes bank dividends contingent and contestable to a greater degree than ever before. Bank regulation in the United States has always imposed dividend restrictions. This makes sense; after all, dividends and other capital distributions transfer capital from the bank to the bank’s stockholders, reducing the amount of funds available to absorb unexpected losses. On the other hand, a privatized system of bank finance relies on investors to provide equity capital. And these investors expect dividends and other distributions. Because the CCAR expands the range of scenarios over which bank supervisors restrict bank dividend policy, it should increase the cost of bank equity on the margin. One way to view the CCAR, then, is an attempted corrective for the supra-normal returns on bank equity that implicit government support has made available for the stockholders of the largest institutions.

While the CCAR is new, bank regulatory dividend restrictions are not. Each successive burst of banking law reform has provided for some regulation of dividends and other distributions. Today, however, these restrictions are largely obsolete because they are triggered only by extreme scenarios (e.g., a bank is in arrears with its FDIC assessments). In today’s highly leveraged and opaque financial markets, these traditional dividend restrictions apply only when it is already too late.

With the Federal Deposit Insurance Corporation Improvement Act (1991), or “FDICIA,” Congress reshaped bank supervision by providing for a sliding scale of regulatory intervention authority calibrated to bank capitalization levels. Under FDICIA, as a bank’s capital levels decline, regulators are empowered, and eventually required, to intervene (including by restricting bank dividends) at earlier trigger points – not just during the extreme scenarios that triggered dividend regulation in the pre-FDICIA era.

The problem is that FDICIA didn’t work. At all. In the lead-up to the 2008 crisis, bank supervisors stood by and watched the banking system not only take on outsize credit risks, but also hemorrhage capital through share buybacks and dividends. Bank holding company dividends increased every quarter from 2005 through 2007 – a period in which weak signals of impending collapse were piling up. They even remained high throughout 2008. The effect was that when mortgage credit losses spiked, there was very little capital available in the system.

The CCAR program reinvigorates dividend regulation by widening the range of operating conditions in which regulators are authorized to restrict the outflow of capital from the banking system. It does so by creating a two-part supervisory mechanism as an ongoing feature of bank supervision. First, the CCAR requires banks to submit capital plans detailing their capital planning processes (including anticipated capital raises and capital distributions) to the Federal Reserve. Second, the Federal Reserve stress tests the bank’s balance sheet according to baseline, adverse, and severely adverse scenarios. This year’s severely adverse scenario assumed an increase in the U.S. unemployment of 4.0%, a spike in oil prices to $110/barrel, a decline in real U.S. GDP of nearly 4.50%, a 60% decline in equity prices and a 25% decline in home prices. The bank must demonstrate its ability to maintain compliance with regulatory minimum capital requirements in the future, hypothetical adverse scenarios. Otherwise, the Federal Reserve will object to any dividend distributions proposed in the capital plan. The CCAR thus formalizes a procedural hurdle to the payment of bank dividends, and shifts the burden to the bank to show its robustness to a hypothetical stressed operating environment.

The second aspect that merits attention is the extent to which the CCAR requires regulators to use their discretion to gauge banks’ susceptibilities to future, uncertain risks. To appreciate this point, consider that the CCAR does not merely expand the range of operating conditions over which supervisors are authorized to intervene in bank dividend policies; it also invites supervisors to make such interventions based on discretionary judgments about how to set the stress scenarios. No longer does the legality of the intervention depend on a rigid, binary determination based on a snapshot of accounting capital (as with FDICIA) or payment defaults (as with, e.g., FDIC assessments).

I should clarify that I am not suggesting supervisors lacked authority to exercise their discretion to enjoin dividends in the pre-CCAR era. Bank supervisors have been authorized since 1966 to issue cease-and-desist orders on banks and bank officers engaging in “unsafe and unsound practices,” a category of practices that courts have interpreted broadly to include, among other things, excessive dividend payments. The novelty of the CCAR is that it cements the exercise of this regulatory discretion as a periodic, ongoing feature of the supervisory process.

My third observation concerning the CCAR is really an invitation for further research. The CCAR is an example of a type of regulatory initiative that EHS regulation scholars refer to as risk regulation. One of the curiosities of financial regulatory theory and practice is that although the main concern of supervisors is to regulate the creation, management, and trading of risk, financial regulators and scholars rarely engage with this broader concept of risk regulation.

What are the essential features of a risk regulatory program? One way EHS scholars distinguish risk regulatory programs is by isolating two program components: first, a trigger mechanism that authorizes the agency to act on the basis of an anticipated, but ultimately uncertain, harm; and second, a standard specifying the level or stringency with which it should regulate the harm or the factors it may consider in doing so.

The risk regulation model is a useful frame within which to situate the CCAR and similar supervisory initiatives. First off, it confronts head-on the necessity of basing regulatory intervention into otherwise private activity on a discretionary assessment of an uncertain, hypothetical, and conjectural harm. It is no objection that the harm has not yet occurred. The uncertainty of the harm is a feature, not a bug, of the system. Second, it underscores the necessity of institutionalizing a deliberative administrative process within the agency concerning the harm. By formalizing a process for supervisors to use their discretion to formulate hypothetical stress scenarios, the CCAR counteracts the tendency, confirmed by both pre-crisis and post-crisis experience, for supervisors to hesitate when it comes to intervening based on harms that might, but might not, occur. Third, and most importantly, financial regulators have much to learn from EHS risk regulators, who have been wrestling for decades with normative debates about accountability, democratic legitimacy, efficiency, and the integration of science into policy and law that will undoubtedly become more pronounced in the financial regulatory field as these initiatives proliferate.

The preceding post comes to us from Robert F. Weber, Associate Professor of Law at Georgia State University.  The post is based on his article, which is entitled “The Comprehensive Capital Analysis and Review and the New Contingency of Bank Dividends” and available here.