Federal Reserve governor Michael Barr said he favors “prioritizing the rigor of the stress testing framework by separating stress testing from binding regulatory capital requirements, which would instead be increased commensurately”.
“Decoupling the stress test results from the preliminary SCB [stress capital buffer] would enable the Board to preserve essential aspects of stress testing, including the generation of credible and detailed information on the risk exposures of banks and how their capital levels would be affected by a stress event. Such information would be valuable in the supervision of banks in normal times and especially important if banks and the financial system are again threatened by crisis,” he said.
If the stress tests are no longer used to inform the calculation of a firm’s preliminary SCB requirement, then the legal justification for publishing the models and scenarios for comment would be eliminated, he added.
The Fed could approach these statutorily required tests primarily as a supervisory exercise and could thereby retain flexibility to design and adjust the models and scenarios as appropriate to ensure their rigor and robustness. Moreover, as authorized by the Dodd-Frank Act, the Fed could run multiple scenarios to provide greater dimension to the assessment of risks.
“This proposed approach of decoupling the stress tests from regulatory capital and increasing regulatory capital to make up the shortfall in the SCB appears to me to be the best way to retain the value of stress testing as a supervisory exercise while maintaining appropriate levels of capital in the system,” said Barr.
However, replacing the current framework of individualized SCBs — informed by firm-specific stress test results — with broadly applicable, formulaic regulatory capital requirements would result in a diminution of the risk sensitivity reflected in SCB requirements. That is, capital levels for firms that are subject to the stress tests would be relatively less tailored than they currently are and less reflective of the unique business models, exposures, and risk profiles of a particular firm.
“To address this loss in risk sensitivity, I would propose that, in exceptional circumstances, the Board could use its capital directive authority to impose individualized capital requirements on specific firms to account for a firm’s particular circumstances, including its capital structure, riskiness, complexity, financial activities, and other appropriate risk-related factors,” he said.