By Pete Schroeder and David Henry
(Reuters) – As Wall Street awaits President Donald Trump’s vision for financial regulation, big U.S. banks are pushing for a lucrative change his appointees can execute without a legislative fight: easing annual stress tests.
First conducted by the Federal Reserve in 2009 to increase confidence in the system, bankers say the tests have morphed into a mysterious, laborious and time-consuming process from what was once a straightforward exam of financial strength.
The outcome determines how much capital banks must hold, and how they can use what is left. But getting a passing grade can be tough. JPMorgan Chase & Co <JPM.N>, the biggest U.S. bank, calls on hundreds of employees to work on stress test submissions each year. Morgan Stanley <MS.N>, the sixth largest, submits a file of over 25,000 pages.
Reducing the tests’ complexity and frequency could not only save man-hours, but help the U.S. economy by stimulating more lending, bankers and lobbyists said in recent interviews.
“While we believe that stress-testing is the best way to gauge capital adequacy, we also believe that a fresh look at how stress-testing is conducted could produce significant benefits for economic growth,” said Greg Baer, president of industry trade group The Clearing House Association.
Bankers have been making their case in meetings with legislators, in reports sent to Treasury Secretary Steven Mnuchin, who is stewarding the financial overhaul by the Republican administration, and in public comments to investors and securities analysts.
Easing up on stress tests could significantly boost returns. For example, Nomura Instinet analyst Steven Chubak estimates JPMorgan could increase annual profits by about $2.5 billion, or 10 percent, under a more relaxed framework.
There are more than a few skeptics pushing back on the industry’s pleas.
Hawkish regulators and former regulators oppose the idea of lightening stress tests too much.
“As proposals for regulatory change swirl about, it is crucial that the strong capital regime be maintained, especially as it applies to the most systemically important banks,” former Fed Governor Daniel Tarullo, who led regulatory matters, said in April. “Neither regulators nor legislators should agree to changes that would effectively weaken that regime.”
Consumer advocates, anti-Wall Street groups and influential lawmakers such as Senator Elizabeth Warren, a Democrat, have also fought any loosening of bank regulations, arguing the industry would embrace reckless practices again.
While bond investors and ratings agencies are happy to see robust capital levels, stock investors are clamoring for banks to boost share buybacks and dividends.
Wall Street analysts have been asking what banks would do with unleashed capital, and the picture is mixed. JPMorgan has said it would like to extend more credit to small businesses and home buyers if the government eases up on lending restrictions. Citigroup Inc <C.N>, in contrast, has emphasized buying back stock because its shares are trading for less than the company is worth.
The industry’s stress-test offensive is happening as Washington re-examines financial reforms, in what will likely be a lengthy and heated debate.
The Treasury Department is expected to release its first in a series of reports on overhauling regulations early next week, while House Republicans are scheduled to vote on their own financial regulatory reform bill.
Despite assurances by Trump that rules will be rewritten, there appears to be insufficient support in Congress. At least eight Senate Democrats would be needed to pass any broad law rewrite, which is unlikely. However, the Fed has broad discretion to make changes to the stress tests.
POOR EXECUTION When it comes to the stress tests, bankers argue that the goal is noble, but the execution is poor.
For instance, the Fed scores loan portfolios for losses under hypothetical economic catastrophes but does not explain its methodology, which changes year-to-year. Even if banks pass numerically, they can fail for “qualitative” problems like risk management. And, in their own calculations, lenders cannot consider steps they would take to conserve capital, something bankers describe as irrational.
“The world will end three times over, but you need to factor in the fact that you probably paid dividends in that time, and you wouldn’t shrink your balance sheet, and you would continue to pursue mergers and acquisitions,” one executive said.
Bankers say they sweat through every year’s process, worried they will miss unseen hurdles. The uncertainty causes them to lend less than they otherwise would, they argue.
The Fed has resisted any wholesale reimagining of stress tests, and major revisions are unlikely until new Fed governors are confirmed. Three board seats including the supervisory post are open.
But there are signs the Fed could become more accommodative. For instance, banks will receive “more guidance” on qualitative matters when stress test results are announced on June 22, Fed Governor Jerome Powell said on Thursday.
Bankers are hoping bigger changes will happen before the Fed issues instructions for the 2018 stress tests early next year.
(Reporting by Pete Schroeder in Washington and David Henry in New York; Editing by Lauren Tara LaCapra and Phil Berlowitz)