Wall Street would have to come up with billions of dollars in additional capital in a proposed revamp of the Federal Reserve’s annual stress tests that could also scrap some provisions that lenders have criticized.
As the Fed has signaled for months, it is considering changes that would raise the minimum capital that the biggest banks need for a passing grade, Fed Governor Daniel Tarullo said Monday. But the Fed is also mulling concessions that Wall Street has sought, such as eliminating its assumption that lenders would continue to pay out the same level of dividends and buy back shares during periods of financial duress, he said.
The plan shows that even after a litany of new rules and capital demands imposed on the biggest banks in response to the financial crisis, regulators still aren’t satisfied that Wall Street is safe enough to endure another economic tsunami. Tarullo, the Fed’s point person on regulation, conceded that the proposal “would generally result in a significant increase in capital requirements” for the largest lenders.
The overhaul tries to incorporate all the new capital requirements into the stress tests, which already represent the highest hurdle that U.S. banks must clear to show they can survive a hypothetical crisis. A particularly heavy mandate for Wall Street giants is an extra surcharge each firm has to maintain based on their size and complexity. For JPMorgan Chase & Co., that surcharge means an extra 3.5 percentage points of capital.
Bank stocks extended their declines after Tarullo’s remarks were made public, with the 64-company S&P 500 Financials Index dropping 1.7 percent at 2:42 p.m. in New York. JPMorgan fell 2.5 percent, Goldman Sachs Group Inc. slid 2.5 percent and Morgan Stanley tumbled 3 percent.
While banks have been anxiously awaiting the Fed’s proposed revamp, they may not have anticipated the agency would add something other than surcharges to the mix.
The central bank also plans to propose swapping out its 2.5 percent capital conservation buffer — one of the pieces tallied into each firm’s capital target — for a new “stress capital buffer” derived from each firm’s own stress-test results, Tarullo said during a speech at the Yale School of Management in New Haven, Connecticut.
That new number is the product of a simple subtraction: How much capital the bank starts with before the stress scenario the Fed hatches, minus how much the firm has at its lowest point in the nine quarters of the hypothetical stress period. If the institution started with 13 percent and dropped to 8, its buffer is 5 percent. And the buffer won’t be allowed to be less than the old 2.5 percent.
The overall capital minimum — which won’t be finished in time for the next round of stress tests — would be the combination of three criteria: an unchanged 4.5 percent base, plus the new stress capital buffer, plus any big-bank surcharge.
Spokesmen for JPMorgan, Bank of America Corp., Citigroup Inc., Goldman Sachs and Morgan Stanley declined to comment on Tarullo’s speech.
When the Fed proposes its rule “early next year,” Tarullo said it will likely include an assumption that banks would only continue paying dividends for 12 months during a period of stress, rather than two years. The central bank also plans to incorporate an assumption that banks won’t increase the size of their balance sheets.
Those changes could make it easier for Wall Street to stomach the boost in minimal capital that they will prohibited from dipping beneath.
The Fed will also free most banks with less than $250 billion in assets from one of the toughest part of the stress tests — the “qualitative” measure that assesses how well they keep track of their capital needs. That exemption, and a plan to reduce some reporting and record-keeping requirements for smaller regional banks, will be formally proposed Monday.
Caught between Wall Street and the smaller firms are some big regional banks and foreign institutions that will face the new stress capital buffer but don’t have a surcharge to tack on. However, because they’d get the benefit of some of the other changes, Tarullo estimated that their capital requirement could be a bit lower overall.
Tarullo said the changes come from the Fed’s recently completed review of its stress-tests. After the overhaul, banks that fall below their new capital minimums will have a harder time winning approval to boost dividends, buy back stock and give bonuses to executives.
Tarullo suggested the Fed will also tweak some of the economic assumptions it uses, including unemployment and housing statistics, and it will better consider the kind of funding shocks, liquidity pressure and fire sales that are usually happening in a time of crisis. That could mean additional headaches for megabanks.
“All of this will make it harder for the biggest banks to pass,” Jaret Seiberg, an analyst at Guggenheim Securities, wrote in a Monday research note.
By Jesse Hamilton