CLS Blue Sky Blog

Cleary Gottlieb Discusses Fed’s Final “Stress Capital Buffer” Requirement

On March 4, the Federal Reserve finalized a significant integration of its stress testing regime with its ongoing supervisory capital requirements, by introducing a new “stress capital buffer” requirement for firms subject to the Federal Reserve’s CCAR supervisory stress tests. An institution-specific stress capital buffer will be determined for each CCAR firm as part of the 2020 CCAR exercise and is intended to take effect October 1, 2020. However, given the uncertainty and stress in the market caused by COVID 19 mitigation measures, it remains to be seen whether the Federal Reserve could modify the implementation timeline.

The Federal Reserve’s supervisory stress test regime is, and almost certainly will continue to be, the binding capital constraint on most CCAR firms. The Federal Reserve touts the stress capital buffer and related changes as “simplifying” and part of its “recent efforts to improve the efficiency and risk-sensitivity of its regulations”.
One key simplification is the elimination of the “pass/fail” quantitative assessment. Accordingly, CCAR now becomes primarily an exercise in calculating a CCAR firm’s stress capital buffer. Beginning October 1, 2020, the stress capital buffer will become a day-to-day ongoing capital requirement in order for CCAR firms to avoid restrictions on capital distributions. This ends the prior CCAR regime’s single-point-in-time approach to evaluating capital plans, which allowed CCAR firms’ pre-stress-test capital to decrease (within bounds) in between the CCAR supervisory stress tests.

The final rule generally adopts the proposal released in April 2018, but includes several welcome modifications. Significantly, the Federal Reserve formally discarded the proposed “stress leverage buffer” that would have applied to the Tier 1 leverage ratio and eliminated post-stress leverage capital requirements. CCAR firms no longer must maintain Tier 1 capital above the minimum Tier 1 leverage ratio or minimum supplementary leverage ratio throughout the nine quarters of the hypothetical stress scenario in order to avoid restrictions on their capital distributions. But one anticipated modification to eliminate the requirement to “prefund” one year of common stock dividends was not incorporated into the final rule, despite Vice Chair Quarles’ stated support in recent remarks. Other modifications, such as permitting CCAR firms not to incorporate material business plan changes into the calculation of their stress capital buffer and elimination of the pre-approval requirement for capital distributions above a CCAR firm’s original planned distributions, will provide more flexibility to make distributions.

Included below are (i) an illustration (Figure 1) of the U.S. risk-based total capital and buffer requirements (including the stress capital buffer) as they compare to the Basel capital framework, (ii) a graphical timeline (Figure 2) for the annual implementation of the stress capital buffer and (iii) a summary of and certain key observations on the final rule.

Overview of the Final Rule

The stress capital buffer rule (“SCB rule”) purports to simplify the Federal Reserve’s current capital and stress testing requirements by tailoring the capital conservation buffer (“CCB”) to incorporate the post-stress losses of a subject firm (“CCAR firm”) under the Federal Reserve’s Comprehensive Capital Analysis and Review (“CCAR”).

— Scope of Application. The SCB rule is relevant only for CCAR firms, i.e.:

These are the BHCs and IHCs identified in Categories I through IV under the Federal Reserve’s recently revised enhanced prudential standards. Non-CCAR firms are not materially impacted by the SCB rule. For non-CCAR firms, the capital conservation buffer remains a fixed 2.5% of common equity tier 1 (“CET 1”).

— The Stress Capital Buffer and its Calibration. The SCB rule redesigns the CCB for CCAR firms by replacing the fixed 2.5% CCB with a dynamic and bespoke “stress capital buffer” (“SCB”). A CCAR firm’s SCB will be recalibrated with each CCAR supervisory stress test (annually for Category I, II and III firms, and every other year for Category IV firms). The SCB is the sum of:

(i) the maximum projected decline in a CCAR firm’s CET 1 capital ratio (starting with the actual ratio as of December 31 immediately prior to the CCAR nine-quarter horizon) under the CCAR supervisory severely adverse stress scenario (expressed as a percentage of risk-weighted assets (“RWA”)), and

(ii) a CCAR firm’s planned common stock dividends for the fourth through seventh quarters of the nine-quarter CCAR planning horizon (expressed as a percentage of projected RWA for the quarter in the CCAR horizon in which the firm’s projected CET 1 capital ratio reaches its minimum under the supervisory severely adverse scenario).

The SCB would have a 2.5% floor. Based on 2019 Dodd-Frank Act Stress Test (“DFAST”) results, the SCB for CCAR firms could have ranged between 2.5% and over 8%, although the median decline in CET 1 for all CCAR firms was approximately 3%.

— Elimination of the Quantitative “Pass/Fail”.

— Reconsideration Procedure.

— What Happens After CCAR Calculation of the SCB?

(i) SCB (floored at 2.5%);

(ii) any countercyclical capital buffer (“CCyl Buffer”) that may be in effect (for Category I, II and III firms); and

(iii) for global systemically important BHCs (“GSIBs”) only, the greater of the firm’s GSIB surcharge under method 1 (which aligns with the Basel capital framework’s GSIB surcharge) and method 2 (which reflects a firm’s reliance on short-term wholesale funding and generally results in a higher surcharge) (“U.S. GSIB Surcharge”).

(i) reduce its capital distributions to ensure they would be permitted based on its baseline scenario; and

(ii) notify the Federal Reserve of such adjustments within two business days of receipt of its SCB by resubmitting the Form FR Y-14A summary schedule reflecting the SCB requirement and its reduced planned capital distributions.

Whether a CCAR firm’s adjustments to its planned capital actions would be subject to public disclosure is not clear from the 2020 CCAR instructions or the SCB rule, which provides that the Federal Reserve “may” release information related to such adjustments but does not require such disclosures. Under the current CCAR process, the Federal Reserve releases the post-stress capital ratios of all of the CCAR firms (both without and with a firm’s modifications to its planned capital actions to avoid a CCAR “fail”).

— Ongoing Application of the Standardized CCB.

— Restrictions on Distributions Applicable in the Buffer Zone.

— Elimination of Prior Approval for Distributions. In a change from the proposal, the SCB rule provides CCAR firms with flexibility to increase their planned capital distributions in excess of the amount included in their capital plans without prior approval, provided that such distributions would not cause the firm’s capital ratios to breach its buffers. However, CCAR firms must notify the Federal Reserve of any distribution not previously included in its capital plan within 15 calendar days following the distribution. In addition, the rule would not change the prior approval requirements that continue to apply to redemptions of Additional Tier 1 or Tier 2 capital instruments.

— Income Limitation on Dividends Revised. The rule also clarifies that the Federal Reserve will no longer apply heightened scrutiny to planned dividends that would exceed 30% of a CCAR firm’s after-tax net income available to common shareholders, primarily because CCAR firms must effectively prefund their dividends, through their SCB, for the intervening year between CCAR cycles. This limitation was not part of the stress testing regulations, and had previously only been highlighted in the Federal Reserve’s instructions and guidance to CCAR firms.

— Distinction Between CCAR and DFAST Collapsed. The SCB rule collapses the prior distinction between the DFAST and the CCAR supervisory stress tests in several ways:

— Revisions to CCAR Assumptions.

A CCAR firm will, however, include in its SCB and its Standardized CCB (i.e., “prefund”) four quarters of planned common stock dividends (but not repurchases or redemptions). However, as with the current DFAST assumptions, the Federal Reserve will assume that payments (equal to the stated dividend or contractual interest or principal due in a quarter) on all outstanding Additional Tier 1 and Tier 2 capital instruments will continue uninterrupted. Therefore, in effect, these payments will be enveloped within the capital reductions that become part of the firm’s SCB, and effectively prefunded across the nine-quarter horizon through a different mechanism.

Additionally, the rule provides an assumption that a firm’s leverage ratio denominator and total RWA would generally remain unchanged over the planning horizon.

— Revisions to Regulatory Reports. The SCB rule also modifies two reports, the Consolidated Financial Statements for Holding Companies Report (FR Y-9C) and the Capital Assessments and Stress Testing Report (FR Y-14A), to collect information regarding the SCB requirement.

— Effective Dates.

Key Takeaways

— Stress leverage buffer and post-stress leverage requirements eliminated. As Vice Chair Quarles previewed in a September 2019 speech, the final rule does not include the proposed stress leverage buffer requirement. However, perhaps more significantly, the final rule eliminates Tier 1 post-stress leverage requirements that currently apply to CCAR firms as a function of the quantitative assessment, which is eliminated under the final rule.

— SCB should reduce Tier 1 capital requirements for most CCAR firms although CET 1 requirements for GSIBs will increase. The impact assessment accompanying the SCB rule generally indicates required Tier 1 capital levels will decline in the aggregate across CCAR firms in Categories II, III and IV by approximately $49 billion (a 12% decrease relative to current requirements) and CET 1 levels will decline in the aggregate by $35 billion (a 10% decrease). For the U.S. GSIBs, Tier 1 capital levels are not expected to change, while aggregate CET 1 levels are expected to increase by $46 billion (a 7% increase). Governor Brainard’s dissent attributes projected declines in required Tier 1 and CET 1 capital to “the rule’s substantial reduction in the requirement to prefund distributions [other than four quarters of dividends] and, to a lesser extent, the elimination of any stress leverage requirement (for tier 1) and the assumption of a flat balance sheet.”

— Dividend prefunding requirement preserved. The dividend prefunding requirement remains unchanged from the proposal despite prior remarks by Vice Chair Quarles that indicated he supported its elimination in favor of either (i) activating the CCyl Buffer in a manner similar to the 1% CCyl Buffer that is currently applicable under standard risk conditions in the United Kingdom, or (ii) raising the floor of the SCB from 2.5% to 3%. Neither of these alternatives was adopted, or even alluded to, in the preamble.

— Interplay with the CCyl Buffer. Although Vice Chair Quarles had indicated in prior statements that the Federal Reserve had been considering the implementation of a non-zero CCyl Buffer in the United States as an alternative to the dividend prefunding requirement, the preamble includes no discussion of the level of CCyl Buffer, which is generally determined on an interagency basis annually. No announcement has been made confirming that the CCyl Buffer will remain at 0% for 2020, although a statement regarding the level of the CCyl Buffer for the coming year is generally made in the first quarter. The Federal Reserve rejected commenters’ requests to eliminate the CCyl Buffer if the SCB is adopted and dismissed assertions that the CCyl Buffer is redundant with the SCB. The preamble reiterates that the CCyl Buffer is a macroprudential tool intended to strengthen the resiliency of financial firms and the financial system, by allowing the Federal Reserve to raise capital standards when credit growth in the economy becomes excessive, a prospect that seems increasingly unlikely in the near term given the adverse economic impacts of COVID 19, particularly with the Federal Reserve’s recent announcement encouraging banks to dip into their capital buffers as they lend to borrowers affected by COVID 19. It is unclear how and whether this announcement will affect the ultimate implementation and effectiveness timeline of the SCB rule.

— Mandatorily convertible LTD issued under the TLAC rule not recognized for purposes of SCB requirements. The Federal Reserve declined commenters’ requests to permit recognition of eligible internal long-term debt issued by IHCs to satisfy TLAC requirements as CET1 for purposes of the SCB, given its mandatory conversion feature. The preamble notes that “providing [such IHCs] greater flexibility to satisfy the buffers would be inconsistent with the general principle that larger and more systemic firms be subject to more stringent and risk-sensitive requirements.” In addition, the Federal Reserve noted that “the loss-absorbing capacity of long-term debt issued under the [Federal Reserve’s] TLAC rule is not identical to the loss-absorbing capacity of CET1 capital as the way in which long-term debt could absorb losses varies by circumstance.”

However, the preamble did not address the potential for convertible instruments more generally to be deemed CET 1 for purposes of CCAR if such instruments were issued by a broader set of institutions. While the Federal Reserve could have used the preamble to shut down entirely the possibility that convertible instruments could be recognized on an as-converted basis in future supervisory stress tests, it seems notable that the preamble did not take that approach.

The SCB rule does not alter the TLAC buffers for U.S. GSIBs and IHCs that have been in place since 2019. If covered firms breach these buffers, they would also become subject to restrictions on capital distributions (even while remaining above the applicable SCB).

This post comes to us from Cleary, Gottlieb, Steen & Hamilton LLP. It is based on the firm’s memorandum, “Observations on the Federal Reserve’s Stress Capital Buffer Final Rule,” dated March 16, 2020, and available here.

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