Fed’s stress tests raise concern over financial safety standard

The Federal Reserve’s bank stress tests have intensified concerns about the impact of a tough new financial safety standard that the industry is fighting and the Trump administration has warned could undermine market stability.

Goldman Sachs, Morgan Stanley and State Street came within a couple of percentage points of breaching required levels in the test, which probes how bank balance sheets would cope during a market meltdown.

The buffer above the minimum level permitted under the contentious new standard, known as the “supplementary leverage ratio” (SLR), is narrow enough to raise questions about how much cash they will be allowed to return to shareholders.

“What the stress test results reveal is just how much of a constraint the SLR is for certain banks,” said Luigi De Ghenghi, a partner at the law firm Davis Polk & Wardwell.

The metric is designed to pick up on dangers that could be lurking in the financial system but are not caught by traditional measures of banks’ financial strength.

It forces banks to include exposures to assets they hold off balance-sheet — activities blamed for contributing to the last crisis — and also prevents them from “risk-weighting”, a technique that typically leads to less onerous capital requirements.

Bankers are critical of the ratio, which is seen as especially punitive for some custodians and investment banks with chunky derivative books.

Jamie Dimon, chief executive of JPMorgan Chase, said in a letter to shareholders this year that the metric should “at a minimum, be significantly modified and balanced to promote lending and other policy goals”.

Steven Mnuchin, Treasury secretary, this month recommended a shake-up as part of wide-ranging financial deregulation.

Investors will this week be told the size of dividends and share buybacks they can expect from US banks as the Fed publishes the results of the stress tests’ second round, known as the CCAR.

Banks have already submitted capital return plans to the Fed, but they can make more conservative payout plans if, based on the first-round results, they think regulators will reject them.

“It’s possible the closeness of the result in the SLR will motivate a change of distribution for some firms,” said Michael Alix, a PwC partner and former senior supervisor at the New York Fed.

[The SLR metric should] at a minimum be significantly modified and balanced to promote lending and other policy goals

The bank that came closest to breaching the SLR requirement in the stress test was Morgan Stanley, whose ratio drops as low as 3.8 per cent under the Fed’s “severely adverse” scenario.

That is above the 3 per cent threshold, although if the ratio were to drop below 5 per cent regulators would apply restrictions to capital distributions and bonus payments.

Goldman Sachs’ drops as low as 4.1 per cent in the Fed’s hypothetical economic meltdown and State Street’s as low as 4.2 per cent.

Brian Kleinhanzl, analyst at KBW, said Goldman’s relatively low SLR score meant the bank may get the green light from the Fed only for lower capital returns than he had expected.

Meanwhile, analysts at Evercore ISI led by Glenn Schorr said State Street’s stress test performance under the SLR, as well as the related tier 1 leverage ratio, was “too close for comfort”.

Goldman, Morgan Stanley, State Street and JPMorgan declined to comment.

The Treasury paper on deregulation this month said it was “important to address unfavourable impacts these requirements may have on market liquidity and low-risk assets”. Cash on deposit with the Fed would be excluded from the SLR under the mooted liberalisation.

And last week, Jerome Powell, the Fed governor in charge of financial regulation, appeared to suggest the new standard could cause “perverse incentives” and “distortions in money markets and other safe asset markets”. He said the regulator was taking a “fresh look” at part of the requirements.

Analysts said the stress test results boded well for the sector overall and they expected most banks to increase capital returns. “Most of the CCAR banks have enough post-stress capital capacity to payout the dollar amounts that we’ve been expecting,” said Evercore.

Additional reporting by Barney Jopson and Sam Fleming in Washington

An earlier version of this article referred to Goldman Sachs research on the supplementary leverage ratio at JPMorgan Chase. Goldman subsequently corrected its report. The reference has been removed.