Post-crisis, U.S. bank regulators have imposed capital requirements that are very high relative to historical norms and current international standards. They have also introduced more granular capital requirements, determining the risk of each type of asset and imposing a particular capital requirement on it. This raises the issue of whether these requirements have made a fundamental change in U.S. finance. Historically, banks decided how to allocate capital, and, thus, which businesses to enter or exit and which loans to underwrite based on risk-adjusted returns on capital; bank capital requirements ensured that a cushion of capital was available if the bank erred in its judgments. Under the current regime, regulatory capital requirements are so high and granular that they may be driving banks into or out of certain asset classes.
This article summarizes a recent research note published by The Clearing House that examines which types of bank customers are being favored and disfavored by post-crisis regulatory capital rules – most notably, the Federal Reserve’s Comprehensive Capital Adequacy Review (CCAR) stress test. The post-stress capital ratios are the binding capital constraint for the majority of large banks, meaning that it requires more capital than other approaches to measuring capital adequacy, such as, for example, the Basel III standardized approaches to capital, which are a series of simplified models for measuring credit, market, and other risks agreed to among global regulators, including U.S. regulators. A bank’s incentive structure is largely dependent on which constraint is binding. Although the models used by the Federal Reserve in its CCAR stress test aren’t available to the banks or the general public, the research article reverse-engineers the capital requirements imposed by the stress tests for various asset classes using the reported post-stress regulatory capital ratios, controlling for differences in portfolio composition and equity distributions across banks.
The Federal Reserve’s CCAR stress test imposes dramatically higher capital requirements on certain asset classes than bank internal models (approved by the Federal Reserve) and Basel standardized models.
The research note then compares those capital requirements with the capital requirements derived from banks’ own modeled results in the Federal Reserve’s stress test process, referred to as the Dodd-Frank Act Stress Tests, or DFAST. Those requirements reflect the capital requirements banks would impose on themselves if risk management and credit underwriting were left to them. It also compares the Federal Reserve’s CCAR capital requirements to those imposed under the Basel standardized approaches to capital.
The results show that the Federal Reserve’s CCAR stress test imposes significantly higher capital requirements on certain asset classes – most notably, small-business loans and residential mortgages – than bank internal models used under DFAST, and approved by the Federal Reserve, and Basel standardized models. Thus, regulation appears to be playing a significant role in determining how capital is allocated and credit is underwritten.
Which Regulatory Capital Ratios Are More Likely to Bind in the Current Regime for Large Banks?
The current framework to assess the capital adequacy of large U.S. banks is complex. Under the Basel III standardized capital requirement as implemented in the United States by the federal banking regulators, U.S. banks are subject to three risk-based capital ratios (the common equity tier 1 capital ratio, the tier 1 capital ratio, and the total capital ratio) and two non-risk-based capital ratios (the tier 1 leverage ratio and the supplementary leverage ratio). Banks having at least $50B in total assets – which includes the banks analyzed in the article – are also subject to U.S. stress tests in which banks’ capital adequacy is assessed using four hypothetical stress scenarios. After these stress scenarios are applied, capital adequacy is assessed using four different ratios — three of which are risk-based and one of which is leverage-based, which under the stress tests is more sensitive to the risk of banks’ portfolios. (Note: In addition to the standardized approach ratios, bank holding companies with at least $250B in total assets or at least $10B in foreign exposure must calculate their risk-based capital ratios under the so-called “advanced approaches” framework and are subject to a supplementary leverage ratio. In the U.S., the 13 bank holding companies subject to the Advanced Capital Adequacy Framework (Advanced Approaches) are American Express Co., Bank of America Corp., Bank of New York Mellon Corp., Capital One Financial Corp., Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley, Northern Trust Corporation, PNC Financial Services Group Inc., State Street Corp., U.S. Bancorp, and Well Fargo & Co. Loosely speaking, Advanced Approaches banks are bank holding companies allowed by the Federal Reserve to assign risk-weights to their own exposures using internal Fed-approved models.)
As noted, there are two stress tests used: CCAR and DFAST. The resulting post-stress capital ratios under each stress test depends on three inputs: (i) the stringency of the macroeconomic stress scenarios, (ii) the models used to project losses and revenues, and (iii) equity distributions. The macroeconomic scenarios for each stress test are identical. One major difference between DFAST and CCAR is that CCAR incorporates BHCs’ proposed capital outflows and assesses their capital planning processes. In addition, under CCAR, equity distributions follow banks’ equity payout forward-looking assumptions under their baseline scenarios, while under DFAST, the assumptions on capital actions are generally more backward looking. The remainder of the article focuses on the post-stress capital ratios resulting from use of the Federal Reserve’s models under CCAR and banks’ own models under DFAST.
The capital surplus is the amount of capital in excess of the most binding, or stringent, regulatory capital requirement across all capital requirements. Figure 1 depicts the capital surplus for all banks that participated in the stress tests over the past three years. As shown in the figure, the capital surplus rose to 1.8% of risk-weighted assets in 2016 from 1.1% in 2015 and 1.0% in 2014. That is, over the past three years, the capital surplus of large banks nearly doubled.
Figure 2 shows the capital requirements that are most likely to be a constraint for the banks included in our analysis. For instance, the post-stress capital requirements under CCAR and banks’ own DFAST (in gray and green) yield the lowest capital surplus for approximately 60% of large banks in 2016. Conversely, Basel III capital requirements (in red and blue) generate the lowest excess capital for the remaining 40% of the sample, of which one-quarter of banks are more likely to be constrained by the supplementary leverage ratio. In summary, the results of Figure 2 indicate that the post-stress capital requirements are the tightest for the majority of large banks over the past 3 years.
Risk-Weights under Stress Tests and Capital Requirements
The previous section shows that post-stress capital requirements under CCAR and banks’ own DFAST are the binding requirement for the majority of large banks. The stress tests map a bank’s balance sheet into post-stress regulatory capital ratios, and so can also be viewed as a process that generates risk-weights that can then be applied to exposures on the balance sheet. The research note estimates the implicit risk-weights in CCAR using the Federal Reserve’s projection of banks’ post-stress regulatory capital ratios as well as information on banks’ balance sheets. Specifically, a model is used to estimate the risk-weights that would best describe banks’ post-stress regulatory capital ratios under the severely adverse scenario, controlling for differences in equity distributions across banks and portfolio characteristics. The analysis is repeated using banks’ own DFAST submissions to analyze differences between the Federal Reserve’s models and banks’ own stress test estimates.
The note shows that risk-weights under CCAR are higher than risk-weights under banks’ own DFAST results for the following portfolios:
- For commercial and industrial loans, implicit risk-weights are estimated to be between 190% and 200% under banks’ own DFAST submissions across the three post-stress regulatory capital ratios, and are estimated to be between 215% and 250% under CCAR – so, 20% higher.
- For small-business loans, implicit risk-weights are estimated to be between 250% and 370% under banks’ own DFAST submissions across the three post-stress regulatory capital ratios, and are estimated to be between 360% and 530% under CCAR – so, 45% higher.
- For first-lien mortgage loans, implicit risk-weights are estimated to be between 105% and 135% under banks’ own DFAST submissions across the three post-stress regulatory capital ratios, and are estimated to be between 105% and 200% under CCAR – so, 25% higher.
- Lastly, for trading assets, implicit risk-weights are estimated to be between 190% and 210% under banks’ own DFAST submissions across the three post-stress regulatory capital ratios, and are estimated to be between 230% and 260% under CCAR – so, 25% higher.
n contrast, for consumer loans and other loans, the estimated implicit risk-weights using the data from banks’ own DFAST submissions are typically higher than the implicit risk-weights estimated under CCAR. So it’s not always the case that banks’ own implicit risk-weights are lower than the implicit risk-weights estimated using CCAR results based on the Federal Reserve’s own models. (Note: For consumer loans, implicit risk-weights are estimated to be about 110% under banks’ own DFAST submissions across the three post-stress regulatory capital ratios, and are estimated to be between 70% and 90% under CCAR – so, 25% lower. For other loans, implicit risk-weights are estimated to be between 110% and 140% under banks’ own DFAST submissions across the three post-stress regulatory capital ratios, and are estimated to be between 25% and 65% under CCAR – so, 65% lower.)
In the second part of the analysis, the research note uses the estimated risk-weights to calculate the amount of capital banks are required to hold for various types of loans, on average, while satisfying the minimum capital requirements imposed by the stress tests under CCAR and banks’ own DFAST submissions. Specifically, capital requirements under stress tests are calculated and compared to requirements under the Basel III standardized approach assuming a bank is bound by the post-stress tier 1 capital ratio under CCAR.
Figure 3 shows the average amount of capital a bank needs to hold for different types of loans under the Basel III standardized approach, banks’ own DFAST submissions, and CCAR. The amount of capital required to hold a particular loan type is derived as follows: Under the standardized approach, the risk-weight for mortgage loans is 50% and the Basel III tier 1 capital requirement for a global systemically important bank (GSIB) is 11% (minimum tier 1 capital requirement of 6.0%, plus capital conservation buffer of 2.5% plus GSIB surcharge of 3.5%); thus, the amount of tier 1 capital required to originate a $100 first-lien closed-end mortgage loan is equal to
Since Basel III capital requirements vary across banks because of the GSIB surcharge, the average amount of capital required to hold a $100 mortgage loan across all banks in our sample is $5.50, and this is the height of the left-most bar in the top panel of Figure 3. Similarly, under DFAST and CCAR, the amount of capital required to hold a $100 mortgage loan for a U.S. GSIB is, respectively, where 115% and 167% are the estimated risk-weights for under banks’ own DFAST and under CCAR, respectively,
For the mortgage loan portfolio, we can make the following two observations: (i) the amount of capital required to hold a mortgage is about 95% higher under CCAR relative to the Basel III standardized approach and 45% higher than under banks’ own DFAST projections; and (ii) the required capital for mortgage loans is higher under CCAR and DFAST, reflecting the higher likelihood of default of such exposures under stress.
As shown in the right panel of Figure 3, small-business loans have a risk-weight of 100% under the standardized approach; however, the implicit capital requirement for small-business loans is twice as high under banks’ own DFAST submissions and three times higher under CCAR relative to the Basel III standardized approach. The significantly higher capital requirements under CCAR and banks’ own DFAST submissions are consistent with the stress test scenarios assuming a recession that includes a sudden increase in the unemployment rate.
Also note that the difference in capital requirements between CCAR and banks’ own DFAST is entirely driven by the more stringent assumptions in the Federal Reserve’s models because the supervisory macroeconomic scenario is the same and the equity distributions are controlled for in the model.
Our results suggest that the capital requirement imposed by the Federal Reserve’s CCAR stress tests is the constraint driving banks’ incentive to provide credit to some sectors and not others, and specifically, that the tests likely encourage banks to reduce exposure to borrowers that are most sensitive to business cycle downturns, such as small businesses and households with less-than-pristine credit scores. Stress tests have, in general, been a beneficial new tool for helping to ensure the safety and resilience of the commercial banking sector, but they are far from perfect. If, as seems likely, the tendency for the tests to divert credit away from these sectors is an unintended rather than an intended consequence of the tests, this effect should be taken into account as the tests evolve.
About the Author:
Francisco Covas is Senior Vice President and Deputy Head of Research, The Clearing House Association. Covas contributes to research and analysis to support the advocacy of the Association on behalf of the owner banks. Prior to joining The Clearing House in 2016, he was an assistant director of the Division of Monetary Affairs at the Federal Reserve Board. Covas joined the Board in 2007 as an economist in the Quantitative Risk Management section of Banking Supervision & Regulation. He previously worked at the central banks of Portugal and Canada.
Covas earned a Ph.D. in economics from the University of California, San Diego, in 2004 and a B.A. from the Universidade Nova de Lisboa, Portugal, in 1997.