WASHINGTON — In response to the COVID-19 crisis, the Federal Reserve took novel steps to measure and strengthen bank capital. But now, the central bank’s top supervisory officials says some extradordinary measures were unnecessary, and the Fed could have just stuck with its normal stress test regime.
Due to the pandemic, the Fed complemented its June 2020 stress tests with “sensitivity analyses” assessing how the largest banks’ balance sheets would respond to various economic recovery scenarios. Based on those analyses, the results of which were published June 25, the Fed blocked share repurchases and capped the dividend payments banks could make to shareholders.
But Fed Vice Chair of Supervision Randal Quarles said, based on how banks have navigated the crisis, it is evident now that their capital levels would have remained adequate without those shareholder restrictions. That calls into question the need for irregular stress test exercises, he said.
“With the benefit of hindsight, I think it’s now clear that we could have not imposed those distribution limitations [and] the banking system would have been fine,” Quarles said Thursday at a virtual event hosted by the Federal Reserve Bank of Atlanta.
The comments echo earlier remarks he made in June touting the potential of the Fed’s standard stress test regime to measure bank capital strength during both normal conditions and crises.
“With the benefit of hindsight, I think it’s now clear that we could have not imposed those distribution limitations [and] the banking system would have been fine,” said Fed Vice Chair of Supervision Randal Quarles.
Quarles said without knowing how the economic crisis of the past year was going to play out, the Fed was right to take the extra steps it did. But he suggested that current analyses of the economic environment show that those steps were not required.
“Given the uncertainty that existed at the time, I don’t think it would have been prudent for us” not to impose restrictions, “but it underscores that doing something like this should be extraordinarily rare.”
It is unclear if other Fed board members such as Chair Jerome Powell or Gov. Lael Brainard share Quarles’ view. A Trump appointee, Quarles is slated to hold his vice chair title until his term ends in October. (He can remain a Fed governor until 2032.)
Some have speculated that Brainard, appointed to the Fed board in the Obama administration, could succeed Quarles as the central bank’s top supervisory official. The two Fed governors have clashed on numerous issues related to supervising large banks, with Brainard dissenting from several recent board decisions.
The core of the Fed’s stress test regime is a measure known as the stress capital buffer, which was established in March 2020 in an effort to streamline the regime and consolidate several requirements.
Under the new system, each bank subject to the Comprehensive Capital Analysis and Review has to meet a unique benchmark based on its performance of how much capital to hold in the following year to combat stress.
But the Fed created the accompanying “sensitivity analyses” out of concern that the economic scenarios developed before COVID-19 started spreading were outdated once the pandemic was in full force.
Quarles suggested it is now evident that the regular stress tests would have been sufficient to ensure banks had enough capital. He said deviating from the normal regime should be reserved for more dire circumstances.
The Fed “should be loath to repeat something like that” in the future, he said of the sensitivity analyses and shareholder restrictions.
“It really does require an asteroid flaming in the sky, and our regular framework has demonstrated itself to be extremely adequate for even unprecedented situations,” Quarles added.
The Fed has yet to make a decision as to what limits, if any, it might impose on bank dividend payments and share repurchases in the second quarter, after easing some of the restrictions that were in place for most of 2020 for the first quarter of this year.
Quarles did concede that the pandemic has made it more challenging to account for risks on banks’ balance sheets. For example, current models to evaluate credit quality do not take into consideration the effects of government stimulus programs, which may hide the true condition of certain loans.
“The programs put in place to help those borrowers are critical for our recovery but will further complicate risk modeling as borrower stress may be obscured by temporary stimulus,” he said.
It is difficult to discern whether borrowers are able to continue making payments because of stimulus efforts, or because they have continued to earn income during the pandemic, he said.
“Borrowers benefitting from temporary forbearance may or may not be able to resume payments once the forbearance ends,” he said.
Separately, Quarles also said the Fed plans to look into how to “reduce the volatility” in stress test results without compromising their rigidity or significance.
“Not every aspect of a supervisor’s work can be quantified,” he said. “But I believe that there is room for supervisors to be more transparent about their analytical processes in general, and more forthcoming about the data used as the basis for supervisory judgments.”
During Quarles’ tenure, the Fed has provided more information to the public on its stress testing models in an effort to be more open about how it tests bank capital against various economic scenarios.
But there is still room for improvement in the Fed’s stress-testing framework, Quarles argued.
“Over the longer term, we must continue to sharpen our thinking around the interrelationships between bank risk and broader changes, such as advancing technologies and growth in nonbank finance,” he said. “Those forces are undoubtedly altering bank risk, and it will take creative and timely research to understand the implications.”