The Regulatory Reality

16 Dec 2020
Read Time 3 mins
Categories :
Bank Capital

Later this week, the Federal Reserve will be issuing the results of its second round of stress tests for 2020, offering an important update on the health and safety of the largest banks in the country.

Capital is central to the strength and performance of our banking system. The stress tests have become a pivotal exercise for supervisors to measure capital adequacy and the results are widely anticipated by the public.  This year, the machinery of stress testing has been retooled to provide a real-time assessment of large bank resilience during a sudden and severe downturn caused by a global health crisis. 

The role of the supervisors this year, and the robust capital maintained (actually increased) by the largest banks, belie a curious claim that has emerged in recent months:  that bank overseers have rolled back requirements for the largest banks.  It is an unfortunate and misplaced narrative.

In reality, the three main components of the post-crisis framework for the nation’s largest banks – stress testing, capital requirements and mandatory levels of liquid assets – were either left intact or made even more stringent. The safety and soundness of the nation’s largest banks is unmatched worldwide.

Earlier this year, former chairman of the House Financial Services Committee, Barney Frank (D-MA), said it pretty clearly:  “Confidence in America’s financial system is terrific. It’s partly because it’s so regulated,” Frank said. “There is confidence that banks are well capitalized because they are regularly monitored.”

Mr. Frank is right, and the stress tests explain why.  They gauge the ability of banks to not just survive a significant financial shock, but to continue to lend and to support the overall economy during a profound downturn. Over the past several years, the Fed’s hypothetical scenarios have been far worse than the financial crisis itself.  (The current, second stress tests of this year use scenarios that are worse than the expected performance of the economy as impacted by the pandemic.)

Let’s look at the actual results. While theoretical losses assumed by the Fed in previous tests are substantial, they pale in comparison to the capital held by the eight U.S. Global Systemically Important Banks (GSIBs), the members of the Financial Services Forum.  From 2012 to 2020, the average amount of estimated stress test losses was $141 billion for these institutions, compared to an average of $879 billion in Tier 1 capital maintained by the same eight banks. Put simply, the nation’s largest banks maintain on average six times the capital needed to cover stress test losses.

This rigorous stress testing is one point at odds with the misleading “deregulation” narrative.  Another is even simpler:  for the largest U.S. banks, capital requirements have increased, not decreased, in recent years. On average, regulatory capital requirements, inclusive of buffers, more than doubled from 4.5 percent for Forum members in 2015 to 10.4 percent in 2020. Over the past decade, Forum members increased their Tier 1 capital by nearly 40 percent to $950 billion.

Requirements for liquidity, meanwhile, have also increased for the largest banks. Liquidity complements capital and is a measure of the cash and other assets banks have available to meet short-term obligations. 

In 2014, Forum members became subject to the Liquidity Coverage Ratio, substantially tightening their liquidity requirements. And the 2020 finalization of the Net Stable Funding Ratio will only further enhance the stringency of liquidity requirements applied to these firms.

In the past decade, Forum member firms’ high-quality, liquid assets have more than doubled from $1.14 trillion to $2.8 trillion.

The post-crisis regulatory framework has gone through its own real-life stress test this year. The economic recession sparked by the COVID-19 pandemic has acted as a very real shock to the financial sector and the economy.

The GSIBs entered the crisis strong, they aggressively reserved for potential losses and built up capital.  Importantly, this combination of strength and commitment to their customers and communities led to significant support to the economy. 

So far, the eight Forum members have increased lending, including providing businesses of all sizes with $272 billion in loans in just the first quarter. Forum members also dispersed $72.4 billion in loans to more than 850,000 businesses through the Paycheck Protection Program, an important lifeline to the nation’s entrepreneurs. Further, Forum members have helped raise $2.2 trillion in corporate bonds and $339 billion in equity for U.S. companies, allowing them to continue to pay their workers, operate their businesses and meet their funding needs.

There is more work ahead, but we hope the coming months bring continued recovery and relief for the most severely impacted.

Friday’s stress test results will provide the public another assessment of the nation’s largest financial institutions and further demonstrate a post-crisis regime that has grown increasingly rigorous. To suggest otherwise is to ignore the evidence.

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