On Wednesday, the Federal Reserve approved the simplified capital rules for large banks effective stress test 2020, keeping intact the strong capital requirements. Notably, the annual stress test helps reaffirm that the U.S. banking giants are adequately capitalized to survive under a tremendously difficult economic scenario.
The "stress capital buffer," also known as SCB, announced by the Board, combines stress test results with the Fed’s non-stress capital requirements. Specifically, required capital levels would commensurate with the individual bank’s risk profile and expected losses as calculated through the central bank’s stress tests. Notably, the rule, similar to the proposal from April 2018, has been finalized with some amendments.
"The stress capital buffer materially simplifies the post-crisis capital framework for banks, while maintaining the strong capital requirements that are the hallmark of the framework," vice chair for supervision Randal K. Quarles said.
For two years, the Fed has been in the overhauling process of the capital rules with amendments to integrate capital requirements of stress tests and a separate set of requirements. The plan was initiated to make simpler and more straightforward rules for banks.
Amendments to Existing Capital Plan Rules
The SCB brought forward a single, forward-looking and risk-sensitive capital framework for large banks, including JPMorgan JPM, Citigroup C, Wells Fargo WFC and Bank of America BAC, which inculcate meeting eight capital requirements, instead of the current 13. Broadly, results from the Fed's supervisory stress tests, part of the annual Comprehensive Capital Analysis and Review (CCAR), are being used by the SCB for determination of individual bank’s capital requirements for this year. Thus, with the combination of the Board's stress tests and non-stress capital requirements, the new framework is put forward for the large banks.
The SCB framework has been prepared to maintain the strong capital requirements post financial crisis. Specifically, under the new framework, capital requirements for the largest and most complex banks would increase, while less complex banks will face decreased capital requirements.
Per the stress test data from 2013 to 2019, common equity tier 1 capital requirements are likely to increase by $11 billion, up 1% from existing capital requirements. Notably, each bank’s SCB varying in size throughout the economic cycle will depend on several factors, including the bank's risks.
However, to reduce the risk-appetite of banks with further simplification of the framework, proposed stress leverage buffer is not included in the final rule. Therefore, banks are subject to maintain the ongoing, non-stress leverage requirements.
Notably, large banks’ capital has been increased significantly since the first round of stress tests in 2009. The common equity capital ratio in the 2019 CCAR has more than doubled to 12.2% in the last quarter of 2019 from 4.9% in the first quarter of 2009. Moreover, total capital doubled to more than $1 trillion.
Root of the Stress Test
Currently authorized under the Dodd-Frank financial-services law, the stress tests were first introduced after the 2008 financial crisis. During this economic downturn, financial stalwarts like Lehman Brothers collapsed and several other big banks were on the verge of a collapse. Such a situation compelled the U.S. government to infuse billions of dollars into credit markets and safeguard the entire financial system from a collapse.
Though economic uncertainty lingers on Coronavirus, at present, banks are actively responding to every legal and regulatory pressure. In fact, this has positioned banks well to encounter impending challenges. Nevertheless, entering the new capital regime will significantly improve the industry’s long-term stability and security.
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