Fed's Tarullo Eyes More Capital for Big Bank Stress Tests - TheStreet

Federal Reserve Governor Daniel Tarullo proposed tougher capital restrictions for the largest U.S. banks as well as relief for mid-sized regional firms in a broad speech Monday on the future of stress tests that gauge the health of financial institutions.

Receiving the worst news were the eight largest U.S. financial institutions, known as "Globally Systemically Important Banks" or G-SIBs, which have more than $250 billion in assets. Tarullo said they will need to hold significantly more capital than they currently do as part of future stress tests.

The good news for the banks is that they won't have to worry about the so-called stress capital buffer approach, which alters the way firms' capital is determined by regulators, before 2018. The stress buffer, which would replace an existing 2.5% capital reserve, would be set at an amount equal to the maximum drop in a firm's common equity tier 1 capital ratio under the toughest portion of the stress test -- before planned capital distributions like buybacks and dividends are factored in.

"This would generally result in a significant increase in capital requirements" for the largest banks, Tarullo said in a speech at the Yale School of Management. "A firm's buffer requirement would be recalculated after each year's stress test, and its capital plan would not be approved" if the proposal would eat into the buffer under the stress test's baseline projections, he said.

The eight banks expected to be subject to the new tougher capital requirements are Bank of America (BAC) - Get Report , Citigroup, (C) - Get ReportWells Fargo (WFC) - Get Report , JPMorgan Chase (JPM) - Get Report , Goldman Sachs (GS) - Get Report , Morgan Stanley (MS) - Get Report , Bank of New York Mellon (BK) - Get Report and State Street (STT) - Get Report . Some, such as JPMorgan and Bank of America, would reportedly have come close to failing this year's tests if a surcharge that's part of the new approach were included.

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The eight banks are part of a group of 33 large financial institutions that must pass an evaluation known as the Comprehensive Capital Analysis and Review designed to ensure that banks with more than $50 billion in assets have sufficient capital after planned buybacks and dividends to survive a crisis similar to the 2008 economic meltdown. 

The Fed would need to propose and adopt rules to implement the tougher tests and capital requirements and as a result, changes for the mega-banks would not apply for the upcoming 2017 stress tests, which are expected in June.

To explain how the process would work, Tarullo used a hypothetical example involving one of the largest institutions. Such a bank might experience a 5% decline in its existing capital buffer under a stress-test scenario, he said, a figure that would be added to a 4.5% minimum common equity requirement and a 3% G-SIB surcharge, bringing the mandatory reserve to 12.5%.

The impact on capital requirements will likely be greater for biggest firms, Tarullo said. On average, the integration of the surcharge for the eight banks would be "somewhat less than half offset" by simplifying changes to each institution's capital distributions and balance sheet assumptions.

The proposal raises the possibility that the biggest banks will have to set aside even more capital to pass stress tests that have already proved challenging for some, or slim down through divestitures.

Morgan Stanley, for example, received only a conditional pass this year after the Fed said its capital levels were just barely above minimums. The central bank also raised serious concerns about "weaknesses in its capital planning" and shortcomings in its "scenario design practices."

Bank of America and Citigroup have also had trouble with the test in years past.

Tarullo disputed assertions from the banking industry that the additional capital buffers aren't warranted because new regulations implemented as part of the Dodd-Frank Act and additional post-crisis supervisory programs are sufficient.

"It is true that these efforts have improved G-SIB resolvability in recent years. But these efforts are ongoing, rather than complete," he said.

The expanded buffers Tarullo discussed Monday come on the heels of a proposal to add tougher capital buffers related to banks' activities in the physical commodities market. That measure is likely to hit Goldman Sachs the hardest.

The Fed plans to issue later today a proposal that would free smaller banks, those with between $50 billion and $250 billion in assets, from qualitative assessments and reduce the amount of data they must provide, Tarullo said.

"This shift will reduce the intensity of supervision of their capital-planning processes, remove any uncertainty as to supervisory expectations for their firms relative to the largest firms, and eliminate the possibility of a public objection to their capital plans on qualitative grounds, he said.

The measure, which is likely to be adopted in advance of the 2017 tests, should be a boon to regional banks including BB&T (BBT) - Get Report and Regions Financial (RF) - Get Report .

The push for tougher regulatory reviews follows reports earlier this month that the largest U.S. banks may be mulling a legal challenge to the Fed stress tests -- a move that may provoke a backlash on Capitol Hill by emboldening critics to pursue legislation that would break up the banks.

But the Fed's own proposal wasn't free from scrutiny, either.

U.S. Rep. Randy Neugebauer, a Republican from Texas who's not seeking re-election, said he was troubled that Tarullo would make a major policy speech at a university but "cannot be bothered to testify before Congress."

He said he's concerned that the speech comes in advance of a Government Accountability Office report investigating the Fed's regulatory process, which is set to be released shortly.

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