Banks failing stress tests? Not for much longer
The Fed is expected to eliminate pass/fail grades as soon as 2019
WASHINGTON—Some big banks are worried about failing the Federal Reserve’s stress tests on Thursday. It may be one of the last times that can happen.
The Fed is moving toward eliminating passing and failing grades from the annual exams, which test whether banks could continue lending during a severe recession. In future years, perhaps as soon as 2019, a bank’s public grade will instead take the form of a capital ratio that the firm must meet during the following year.
The changes, set in motion during the Obama administration and continuing under President Donald Trump, reflect the Fed’s uneasiness with surprising bankers and financial markets with bad news, such as Citigroup Inc.’s unexpected stress-test failure in 2014.
The modifications also demonstrate how Fed officials have grown more comfortable with big banks’ risk-management chops, after the 2008 financial crisis exposed significant weaknesses. Last year, no banks failed, the first time that happened since the Fed began disclosing annual results in 2012.
For banks, the changes promise less risk to their reputations and less urgency to invest in passing the tests, which can cost firms hundreds of millions of dollars in compliance costs.
The Fed has been steering “a gradual course away from the potential for public shaming,” said Michael Alix, a former Fed official who works as a consultant advising banks at PricewaterhouseCoopers LLP. Instead, he said, the Fed is moving back to the way it typically addressed
risk management issues in the past: privately.
Bank regulators historically have worried about bashing banks in public because it could fuel perceptions that a firm is in trouble, leading to the destabilizing “runs” on banks that regulators are trying to prevent.
Stress tests have been an exception. Officials created the tests during the crisis to increase public confidence in banks. The 2010 Dodd-Frank financial law made annual testing mandatory for large banks, and in 2012 regulators began disclosing individual bank results. After Citigroup failed in 2014 — along with four other firms — Chief Executive Michael Corbat told colleagues, “If we don’t get this right, we don’t deserve to stay in business.”
Citigroup passed the next year’s test, and Mr. Corbat kept his job.
The current Fed grading system has two parts. A quantitative exam forecasts whether bank capital levels stay above regulatory requirements. A qualitative portion looks at more subjective questions, including the quality of a bank’s internal data or board of directors.
A slip-up on either part means the bank fails, and it doesn’t receive the Fed’s approval to increase the profits it returns to shareholders through dividends or share buybacks. The bank can still make previously announced payouts.
The Fed in April proposed changing the first, quantitative part of future stress tests. Under the proposed process, if the Fed
decides a bank’s capital levels are low, the bank would face a higher capital requirement during the following year. To comply, bankers may have to limit shareholder payouts — the same effect as failing the test today, but with a less explicit public rebuke.
The second piece of the Fed’s pass-fail system is also fading. In 2017, the Fed stopped issuing qualitative grades to banks with less than $250 billion in total assets and less than $75 billion in assets in nonbank businesses. As a result, about half of the 35 firms taking this year’s tests don’t face the qualitative grade.
Fed officials haven’t yet proposed scrapping the qualitative grade for the largest banks, including global behemoths such as Wells Fargo & Co. and Deutsche Bank AG, whose U.S. unit is subject to the stress tests. But they intend to do so.
Fed Chairman Jerome Powell said last year, before he took the helm, that banks have made progress and “we’re getting to the point where qualitative supervision of risk management can no longer be part of the stress test.” Fed Vice Chairman for Supervision Randal Quarles said in April this “is something we should consider.”
Fed officials will still be able to put pressure on banks; they just wouldn’t do so as publicly.
The banking industry has praised some aspects of the proposed changes and criticized others.
Two former Fed economists at the Clearing House Association of large banks in May called the Fed’s quantitative proposal “a clear improvement” that nevertheless “makes capital requirements very volatile,” because the test results fluctuate from year to year.
The Fed is reviewing public comments on the draft quantitative changes, which officials hope to implement for the 2019 exams. That would mean next year’s tests only include pass-fail grades based on subjective factors, not banks’ numerical scores.
Next year’s tests may also include fewer firms with less than $250 billion in assets, as the Fed acts on new congressional authority to exempt those banks from the tests entirely.
That would leave the largest banks taking the 2019 tests, with the Fed still able to fail them for subjective reasons. Fed officials haven’t said when they intend to stop issuing pass-fail grades to those firms. They could do so in time for the 2019 tests, or they could delay the change.