Earlier this year, the Federal Reserve held a conference on stress testing transparency and effectiveness. Transparency is an important topic because the stress tests are a critical determinant of bank capital. And transparency ensures that banks and the public can understand and evaluate the choices being made by supervisors — choices that have a direct impact on the cost and allocation of credit in the U.S. economy. In this post, we frame the stress testing and transparency debate in the broader context of the overall bank capital regime. We show that the lack of transparency in the stress tests is at odds with the rest of the bank capital regime. We also show that common arguments to limit the transparency of stress tests are not persuasive when considered in this broader context. Consideration of transparency in stress testing is particularly important now given that members of the Federal Reserve Board have expressed an interest in finalizing a rule that integrates the stress tests into the broader bank capital framework. This integration also requires a comprehensive and consistent approach to transparency in the overall bank capital regime.
Stress Testing within the Broader Regulatory Capital Context
To fully consider the transparency of the stress testing regime, one has to consider stress testing within the broader regulatory capital context. To broaden the context, it is helpful to consider a formula that specifies the minimum amount of common equity capital (k, measured in dollars) a bank holding company (bank) must maintain to be considered appropriately capitalized.
The formula above assumes that the Federal Reserve Board’s 2018 proposal to implement a “stress capital buffer” is adopted. Before delving into the transparency of the bank capital regime, it is worthwhile to briefly explain each of the formula’s components. (The above formula omits the countercyclical capital buffer since its current value is 0 and adding it to the discussion would not change the analysis significantly.)
The first term on the right-hand side of the above equation, risk-weighted assets (RWA), is the total dollar amount of assets held by the bank after adjusting for risk. Specifically, the value of each asset is adjusted so that low-risk assets have a low value of RWA and higher-risk assets have a higher value of RWA. As an example, the RWA associated with a $100 U.S. Treasury security is $0 while the RWA of a $100 loan to a risky start-up company is $100. In this way, the RWA adjustment ensures that less risky assets require less capital and vice versa.
The next three terms in the parenthetical on the right-hand side of the equation are percentages that are summed together to compute a bank’s overall capital requirement. The first term, 4.5%, is the minimum common equity ratio required by regulators. Any bank with less common equity than 4.5% of risk-weighted assets would be effectively deemed “insolvent” by regulators. The second term, GSIB%, is the Global Systemically Important Bank (GSIB) capital surcharge buffer. This percentage reflects an extra amount of capital that must be maintained by GSIB banks – the U.S. GSIBs comprise the Financial Services Forum – on the premise that banks with a larger systemic footprint should be safer and maintain more capital. The third term, SCB%, is the newly proposed stress capital buffer that is based on the Federal Reserve’s annual stress test exercise. Specifically, according to the proposal, each year the Federal Reserve would conduct its stress test and assign each bank a specific percentage value for SCB% based on the central bank’s internal, non-public, assessment of the bank’s risk.
Looking at the broader bank capital regime, one immediately sees that stress testing – through its impact on SCB% – only plays one part in determining overall capital. Accordingly, rather than focusing on “stress testing transparency” in isolation it is more meaningful to consider the transparency of the entire bank capital regime.
Bank Capital Requirements and Public Transparency
As a general rule, banking regulations are subject to strong transparency requirements as a result of the Administrative Procedures Act (APA). Under this law, regulators are required to propose rules, seek comment from the public, and then explain how they have considered and responded to comments in the final rule. The final rule is a public document. The public notice-and-comment requirements of the APA ensure that federal regulators make rules in a fully transparent fashion that gives affected parties and others an opportunity to consider, comment, and understand rules in their entirety. These transparency requirements are a hallmark of good government that serve as a bulwark against arbitrary and capricious regulation.
The RWA rules, the minimum common equity ratio, and the GSIB surcharge are all subject to strong transparency requirements. In particular, any change to these rules is put out for public notice and comment before being finalized and implemented. This is important since each of these components has a direct effect on the overall amount of required capital.
To date, the Federal Reserve has opted not to administer the stress tests in a manner consistent with the way other aspects of the capital regime are administered from a public notice and comment perspective. It is instructive to consider some common arguments for why the stress tests and SCB should not be subject to notice and comment as are other aspects of the capital regime. Table 1 details each component of the bank capital regime and how it is subject to public notice and comment.
Table 1: Bank Capital Regime and Transparency
|RWA||Common Equity Minimum (4.5%)||GSIB%||SCB%|
|All Changes Subject to Public Comment?||Yes||Yes||Yes||No|
|Final Rule/Model Available to Public||Yes||Yes||Yes||No|
Some argue that if the details of the stress test are made public then banks will “game the system.” This argument is hard to square with the fact that RWA rules and the GSIB surcharge methodology are completely transparent to the banks and the public. Indeed, banks make business decisions based on their impact on RWA and the GSIB surcharge since required capital is a significant cost to banks. If regulators have a view that a certain asset is risky or creates greater systemic importance, banks should have an opportunity to manage those risks and the corresponding capital costs. Doing so should be regarded as prudent risk management and not “gaming.” In the case of the GSIB surcharge, regulators have explicitly recognized that it is indeed desirable for banks to be able to manage their GSIB surcharge. Specifically, former Federal Reserve Chair Janet Yellen has remarked that “[i]n practice, this final rule will confront these firms with a choice: they must either hold substantially more capital…or else they must shrink their systemic footprint.” Accordingly, it is difficult to understand why making risk-management decisions in full knowledge of the SCB presents a problem while doing so in the case of the GSIB surcharge is viewed as desirable. This is especially inscrutable when the GSIB surcharge and SCB are perfectly substitutable in the sense that raising the SCB by 1% and lowering the GSIB surcharge by 1% has no effect on required bank capital.
Others argue that the public notice-and-comment process is too lengthy and cumbersome. This is a feature and not a bug. Deliberate consideration of public input should be viewed as a positive feature of the regulatory process. In addition, RWA rules, the minimum common equity requirement, and the GSIB surcharge have all been changed in the past several years. In each case, these changes have been made transparently, through the public notice-and-comment process. If regulators believe that changes to the stress tests, such as changes to stress testing models or changes to scenarios, need to be made quickly, they can choose to allocate more time, staff resources and energy to considering and responding to comments. Accordingly, it is not clear why the notice-and-comment process is too “cumbersome” for stress tests, but not too cumbersome for the other three components of the capital regime.
When viewed as a system, the lack of transparency of the stress tests and SCB are out of step with the rest of the bank regulatory regime. All other factors determining overall capital requirements are subject to public notice and comment, which are a cornerstone of good government. Arguments for less transparency in stress testing are not persuasive when viewed in the broader bank capital regime context. Aligning the transparency requirements for the stress tests and SCB with the rest of the capital regime would harmonize regulatory transparency across the bank capital regime, allow banks to make prudent risk-management decisions and would let the public understand choices made by regulators that have a direct impact on the cost and availability of credit to households and businesses in the U.S. economy.