The Case for Including Capital Buffers in Stress Tests

The Case for Including Capital Buffers in Stress Tests

Since the financial crisis, regulators have subjected the largest U.S. banks to stress tests to ensure they can withstand major shocks. They have also introduced the concept of “capital buffers,” extra cushions of capital held by banks to absorb potential losses under stress.

Left undecided is how capital buffers will be treated in the stress tests. In conducting stress tests, should regulators assume they would require banks to keep their buffers intact, even under stress? Or should they assume banks would be allowed to draw down their buffers?

A new OFR brief analyzes efforts underway to reconcile new bank capital standards, including capital buffers, with U.S. bank stress tests. Authors Jill Cetina, Bert Loudis, and Charles Taylor conclude that including buffers would result in the biggest U.S. banks holding more capital, all else being equal. Under this approach, the buffers would remain intact during the test, so banks would not be allowed to tap into the buffers to pass.

The authors also note that if buffers are not included in the stress tests, the tests could have a bigger impact on less systemic banks.

In September 2016, Federal Reserve Governor Daniel Tarullo said the Federal Reserve was considering including capital buffers in its annual stress test.

The most systemically important U.S. banks are required to hold three capital buffers. One buffer applies to all banks. A second applies to banks that exceed size thresholds. A third buffer applies to banks considered systemically important. Regulators will reduce a bank’s dividend payments and executive bonuses if it taps into one or more of its buffers.

The authors note that another proposal the Federal Reserve is considering could limit the efficacy of the Federal Reserve’s stress tests. This change would allow banks to assume a static balance sheet (unchanged from the prior period) in the stress test. Using a static balance sheet could have adverse effects. For example, banks could lack enough capital to continue to lend during a downturn, or they could be unable to handle unplanned balance sheet growth.

Stacey Schreft is Deputy Director for Research and Analysis at the Office of Financial Research