In December, the Federal Reserve released the second round of stress tests that were conducted in the pandemic year of 2020. The results showed that Financial Services Forum members maintained significantly more capital than was needed to both sustain the severe economic shock contemplated in the December 2020 stress tests and continue supporting the economy. With the release of the stress test results, the Federal Reserve also placed restrictions on bank capital distributions that are not required under existing capital rules. These restrictions will expire on March 31st, unless the Federal Reserve extends them for an additional period of time. The restrictions have been justified by the Federal Reserve on the grounds of unprecedented, elevated economic uncertainty. Current data clearly show that economic uncertainty is no longer elevated beyond its normal range. Extending the restrictions will itself increase regulatory uncertainty, which contributes to economic volatility and creates headwinds for the economy. As a result, the Federal Reserve should allow the existing restrictions to expire at the end of March and rely on the capital framework to govern bank capital distributions. Doing so will bolster the credibility of the stress testing process, reduce economic uncertainty, and provide much needed support to the economy.
Forum Members are Resilient to Future Shocks
The pandemic buffeted the economy with an unprecedented economic shock in 2020. Many people were put out of work and many businesses struggled as social distancing measures crimped economic activity. Despite these headwinds, Forum members showed themselves to be resilient to this unprecedented shock. Over the whole of 2020, Forum members increased their level of common equity capital by more than $62 billion, which is roughly an eight percent increase, despite significant economic challenges. What’s more, the forward-looking stress tests released in December 2020 also clearly show that Forum members are resilient and ready to withstand severe economic shocks. In Figure 1, we show the asset-weighted average minimum common equity Tier 1 capital ratio for Forum members and all other U.S. banks subject to the stress tests. This ratio describes the level of capitalization that would result after a bank is hit by the severely adverse shock contemplated by the stress test. The minimum required common equity tier 1 capital ratio is 4.5 percent.
As shown in the figure, Forum members exhibited a minimum common equity tier 1 ratio of 9.7% after absorbing all of the losses caused by the stress test’s severely adverse scenario. This capital ratio is significantly larger than that of other U.S. banks subject to the stress tests and more than twice the minimum requirement of 4.5 percent. Forum members began the stress tests with an average common equity ratio of 12.4 percent. The severely adverse scenario reduced this capital ratio by 2.7 percentage points. As a result, the stress test indicate that Forum members could withstand the severely adverse shock one more time and still maintain more than the minimum amount of required capital. Accordingly, the stress tests clearly demonstrate that Forum members are well capitalized and resilient to future economic shocks.
Distribution Restrictions and Economic Uncertainty
If Forum members are so well capitalized and resilient to economic shocks, then why did the Federal Reserve impose additional restrictions on capital distributions, such as dividend payments, that are not required under existing capital regulations? While many bank capital experts, such as former Federal Reserve governor Daniel Tarullo, have disagreed with divorcing capital distribution decisions from stringent stress tests, the rationale provided by the Federal Reserve was that uncertainty was so high that they needed to restrict distributions to preserve the resiliency of banks. Accordingly, while the stress tests showed that Forum members have more than enough capital to withstand a severe economic downturn, the Federal Reserve restricted their ability to make capital distributions to shareholders because of heightened uncertainty.
So, if unprecedented and high uncertainty is the main justification for these restrictions, just how high is uncertainty now? Thankfully, economists spend a lot of time measuring economic uncertainty and good data exist on this front.
Figure 2 shows two widely cited measures of economic uncertainty. The first measure is the implied volatility of the stock market as measured through the options market – the VIX index – and is available since 1990. This index is a widely followed and studied measure of financial market uncertainty. The second measure is the amount of dispersion in professional forecasts of GDP and it is available since 1968. The more professional forecasters disagree about the future path of GDP, the more uncertainty there is in the economy. In Figure 2, we have normalized each series by its average for ease of comparison.
Source: Federal Reserve Bank of Philadelphia, Yahoo Finance
Figure 2 provides a useful look at economic uncertainty over a long period of time as well as the past year. It is clear that we did experience a sharp spike in uncertainty in the first quarter and second quarter of 2020. Since that time, however, uncertainty has declined significantly. In both the case of the VIX and the forecast dispersion measure, economic uncertainty is now somewhat elevated, but well within its historical range. Indeed, in the case of the macroeconomic forecast dispersion, uncertainty has been higher than the current level of over one-third of the time. In the case of the VIX, uncertainty has been higher than the current level more than ten percent of the time. Accordingly, while the current level of economic uncertainty is somewhat elevated it is not at all unprecedented.
Regulatory Uncertainty and the Economy
While it may make sense to use “belts and suspenders” in an environment in which uncertainty is at an all-time high and the usual “rules of the road” can’t be fully relied upon, the data clearly show we are not in that situation now. As a result, the Federal Reserve should allow bank capital distributions to be governed by existing bank capital requirements. At the beginning of 2020, the Federal Reserve finished a multi-year effort to reform large bank capital rules though its Stress Capital Buffer (SCB) rulemaking. Moreover, the Federal Reserve’s own analysis showed that the new SCB rule would raise capital requirements for Forum members. The SCB has yet to be implemented because the Federal Reserve is limiting distributions via special restrictions rather than the SCB rule. As economic uncertainty has abated, the time to allow the SCB to determine distributions has come. A failure to return to the existing bank regulatory framework will have a significant adverse consequence on the economy.
Specifically, a failure to return to the existing bank capital regime creates regulatory uncertainty that itself contributes to economic uncertainty. When banks, investors and markets do not understand the rules of the road, they are unable to make decisions or allocate capital, and the economy suffers. This then creates a negative feedback loop, which only increases economic uncertainty and further depresses economic activity. The negative consequences of regulatory uncertainty are real and well documented. As economists at the University of Chicago, Northwestern University and Stanford University have documented, “Policy uncertainty is associated with greater stock price volatility and reduced investment and employment in policy-sensitive sectors like defense, health-care, finance, and infrastructure construction.” Accordingly, a failure to return to existing and robust capital adequacy guidelines will create unnecessary policy uncertainty that will serve as a further drag on the economy.
Forum members are resilient and strong. The stress tests clearly show their collective ability to withstand stress and serve the economy. There is uncertainty in the economy, but it has declined significantly and today sits within its normal historical range. As a result, the Federal Reserve should allow the temporary restriction that were placed on capital distributions in December 2020 to lapse. Doing so would allow the banking system to return to the existing large bank capital regime, which is robust and has been recently strengthened through the Federal Reserve’s SCB rule. A failure to allow the restrictions to lapse will eventually undermine a consistent bank capital regime that our economy depends upon to allow banks to serve the economy while remaining safe and sound.