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Getting to a Financial Stress Test Equilibrium

On May 24, 2018, President Trump signed the Economic Growth, Regulatory Relief, and Consumer Protection Act (“EGRRCPA”). ((Francine McKenna, Newly Signed Bank Deregulation Law Sets Stage for Fed to Take Further Steps, MarketWatch (May 24, 2018 12:53 PM), https://www.marketwatch.com/story/house-set-to-approve-bank-deregulation-legislation-2018-05-21.)) This law loosened several regulatory requirements instituted by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) after the 2008 Financial Crisis. ((See id.)) The EGRRCPA removed, inter alia, a Dodd-Frank requirement that prudential bank regulators and bank holding companies conduct “adverse” scenario stress tests on a bank’s capital structure. ((See Press Release, Board of Governors of the Federal Reserve System, Federal Reserve Board Invites Public Comment on Proposal that Would Modify Company-run Stress Testing Requirements to Conform with Economic Growth, Regulatory Relief, and Consumer Protection Act (Jan. 08, 2019) (available at https://www.federalreserve.gov/newsevents/pressreleases/bcreg20190108a.htm.) )) On January 8, 2019, the Federal Reserve Board (the “Board”) proposed a rule to remove the Dodd-Frank “adverse” scenario stress test requirement for bank holding companies. ((Id.)) The Board’s proposed rule to remove “adverse” stress tests is an important step toward regulatory equilibrium in the financial sector.

Financial transactions are inherently risky, which makes it difficult to find regulatory equilibrium in the banking sector. ((See Frances Coppola, Why We Should Worry about the U.S. Treasury Yield Curve Inverting, Forbes (Dec. 31, 2018 2:19 PM), https://www.forbes.com/sites/francescoppola/2018/12/31/why-we-should-worry-about-the-u-s-treasury-yield-curve-inverting/#280958e16824.)) Banking sector regulation requires balancing leverage and maturity transformation. Consumers want banks to conduct maturity transformation—the process of using deposits or investments to create financial instruments, such as loans—at accessible rates. ((See id.)) Maturity transformation is key for the economy. Much of the United States’ financial system is built on credit accessibility. For example, small businesses use loans to purchase equipment and make payroll, and families need loans to purchase cars and homes.

Banks also want to perform as much maturity transformation as possible to increase profits. ((See id.)) However, untamed maturity transformation creates a leverage problem for banks. ((Id.)) In other words, as a bank lends more money through maturity transformation, it becomes more leveraged, meaning the bank has a high level of debt that it might not be able repay without dissolving its assets. The more money a bank has tied up in loans, the less capital it has readily available to pay depositors who come calling for their cash. ((See id.)) Thus, government regulators, such as the Board and the Federal Deposit Insurance Corporation, attempt to balance desired maturity transformation with proper leveraging.

Dodd-Frank attempted to correct exposed insufficiencies in a financial regulatory regime based on leverage ratios and capital risk-weight ratios. ((Lisa Fu, Is Dodd-Frank Crippling Banks or Saving them?, Fortune (Aug. 4, 2017 11:30 AM), http://fortune.com/go/finance/dodd-frank-choice-act/.)) Prior to the 2008 Financial Crisis, the United States required banks to meet leverage and capital ratios to protect against financial risk. Although, the 2008 Financial Crisis showed proved ratio requirements are necessary for a level of financial protection, they are insufficient to absorb a serious financial crisis. Dodd-Frank instituted sophisticated stress test requirements on many banks to measure how well a bank’s capital structure would withstand potential future financial crises. ((See McKenna, Newly Signed Bank Deregulation Law Sets Stage for Fed to Take Further Steps.)) In addition to prudential regulator supervisory stress tests, Dodd-Frank requires banks to perform complex company-run stress tests. ((See Board of Governors of the Federal Reserve.))

The Board’s proposed rule will remove the “adverse” level of Dodd-Frank’s instituted stress tests. Dodd-Frank regulations currently require three levels of stress testing: “baseline,” “adverse,” and “severely adverse.” ((Regulations LL and YY; Amendments to the Company-Run and Supervisory Stress Test Rules 84 Fed. Reg. 4002, 4002 (Feb. 14, 2019) (to be codified at 12 C.F.R. 238).)) The “baseline” scenario test incorporates “conditions that affect the U.S. economy or the financial condition . . . and that reflect the consensus views of the economic and financial outlook . . . .” ((Id.)) The “adverse” and “severely adverse” scenarios test increasingly dire financial conditions, with the severely adverse scenario test “designed to cover the full range of expected and stressful conditions” that the financial market could experience. ((Id. at 4004.)) The Board’s proposed rule would leave the “baseline” and “severely adverse” scenario tests intact, but it would remove the “adverse” scenario stress test because it has “provided limited incremental information to the Board and market participants.” ((Id.))

Removing the “adverse” scenario test will provide regulatory relief to the banking industry without erasing important protections instituted under Dodd-Frank. Dodd-Frank stress tests are an important tool to measure a bank’s probable reactions to possible future financial crises. A stress test regulatory regime better prepares the financial sector for a potential financial crisis than a simple leverage ratio or capital ratio regulatory regime. However, regulatory stress tests impose a massive burden on the banking sector. ((Michael S. Barr et. al., Financial Regulation: Law and Policy 335 (Foundation Press, 2nd ed. 2018).)) Stress test compliance requires hiring professional personnel and running expensive, sophisticated financial models. ((See id.)) Removing the “adverse” scenario test will ease a portion of the banking sector’s regulatory burden, which will allow banks to use more capital for maturity transformation, creating more accessible financial instruments.

The “adverse” scenario test is an unnecessary regulatory burden. The Board’s proposed rule will leave “baseline” and “severely adverse” scenario testing requirements untouched. Since stress tests increase in severity, moving from “baseline” to “severely adverse,” a bank that passes a “severely adverse” scenario more likely than not would also pass an “adverse” scenario test. In other words, nothing is lost in the regulatory regime by removing the “adverse” scenario test. The “baseline” and “severely adverse” scenario tests are likely sufficient for regulators to measure a bank’s capital strength.

Removing the “adverse” scenario test is likely not severe regulatory capture. Although banks more than likely support the Board’s proposed rule because it provides regulatory relief, the proposed rule is not concerning regulatory capture. The Board’s proposal still keeps the strictest stress tests in place, providing adequate monitoring to the financial system. The Board’s proposed rule is a smart step toward a more balanced financial regulatory regime.

Dodd-Frank increased financial regulation after the 2008 Financial Crisis in part by instituting mandatory stress tests on banks’ capital structures. The Board’s proposed rule from January 8, 2019 brings the Dodd-Frank regulatory regime closer to regulatory equilibrium by maintaining the most important stress tests and removing an unnecessary and burdensome “adverse” scenario stress test.

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Bryan Pistorius