US Stress Tests 2018: the role of regulatory monitoring through stress tests

The Federal Reserve publishes the results of its eighth annual stress test, commonly called CCAR (for Comprehensive Capital Analysis and Review) on June 21st and 28th. The awaited results by investors will be disclosed in two rounds: the quantitative assessment part on June 21st, and the comprehensive part (including the qualitative assessment) on June 28th. The quantitative assessment of the CCAR reviews the capital adequacy of banks, ensuring they have sufficient buffers of capital to absorb severe losses in a stress scenario defined by the Federal Reserve. In addition, the Federal Reserve assesses the capital planning and risk management practices in the qualitative part of the CCAR.

This year, only the 18 largest banks, out of 38 banks subject to the CCAR, will be subject to the qualitative assessment. This reflects an emerging trend in the U.S. to ease regulation (and the cost of it) on banks. Last year, the House passed the Financial Choice Act featuring a variety of reforms to the Dodd-Frank Act. Among the proposals, the « off-ramp » rule would allow banks to be exempted from the CCAR if their capital to assets ratio is above 10 percent.

Results of the research of Prof. Diane Pierret and Roberto Steri, HEC Lausanne

Recent research by Professors Pierret and Steri highlights the role of regulatory monitoring through stress tests (like the CCAR) in reducing the incentives of banks to take risks when banks are subject to higher capital requirements. In their paper  «Stressed Banks», they show the contrasting effect of stress tests on banks’ risk taking. On one hand, stress tests increase bank capital requirements requiring banks to finance themselves with more equity. On average, banks subject to the CCAR face more stringent capital requirements than other banks, namely 6.8% versus 3% of assets. Higher capital requirements increase the cost of funding of banks when equity is costlier than debt. Banks facing higher costs could rationally respond by shifting their portfolio towards more profitable hence risky assets. On the other hand, the authors show that stress tests can dampen the risk-taking channel from higher capital requirements through a more detailed monitoring of the riskiness of banks’ assets. They find that banks examined by the Federal Reserve in the CCAR are more prudent than other banks, after controlling for the former’s response to the more stringent capital requirements they face.  

Their results suggest that higher capital requirements are not a substitute for regulatory monitoring, but actually need to be accompanied by additional monitoring of banks’ asset risk, in addition to capital requirements based on risk-weighted assets in the Basel agreements. While the off-ramp rule has not made it to the Senate, the possibility for such a rule to come forward again, and the debate concerning the cost of the CCAR on banks are still very much there. The analysis of risk-taking incentives of Stressed Banks should be considered in light of this debate.