Caught in CCAR’s Cross-Fire

By Karen Shaw Petrou

  • CCAR now tries to make big banks a shadow U.S. central bank.
  • Result: more systemic risk and still less economic inequality.

How do you make the financial system less stable and increase U.S. economic inequality at the same time?  It’s not easy, but if you’re the Fed, then you accomplish this frightening feat by toughening up the annual CCAR stress test for the biggest banks without an eye to its systemic or market impact.  Stress testing is fine – indeed an important addition to the post-crisis supervisory arsenal.  But, CCAR itself is founded on two flawed premises:  big BHCs are the heart of financial stability and nothing the central banks does adversely affects economic inequality. 

On its own, each premise is demonstrably false – the U.S. financial system is dominated by non-banks and central-bank actions have overtly-distributional impact, as much else on this blog makes clear.  Still worse, CCAR feeds the negative feedback loop between financial-crisis risk and economic inequality, making a couple of really bad things a whole lot worse.

CCAR’s Current Construct

The Fed released its latest CCAR scenarios on February 1, saying that CCAR now is intended as a counter-cyclical force dampening the top of the business cycle.  As a subsequent Brookings article by a former Fed official detailed, the 2018 test is a lot tougher not because big banks are necessarily any riskier, but because CCAR now isn’t just about big-bank resilience; it’s about making big banks a shadow central bank. 

Once upon a time, monetary policy was supposed to take the proverbial punch bowl away.  Now, as the Brookings article clearly states, banks must do it for the Fed because the central bank’s toolkit is close to empty. 

Hyper-accommodative policy not only exacerbates economic inequality, but it also hand-cuffs the Fed because it has no more weaponry with which to lower rates or enlarge its huge portfolio if additional accommodation is required. 

But to make big banks set macroeconomic policy is transformational.  If the banks can’t or won’t step in ahead of the central bank, what then? 

CCAR and Crisis Risk

Even if banks sign up for Uncle Sam and there weren’t a link between economic inequality and financial-crisis risk – and there is – CCAR on its own makes each big BHC safer at the expense of the stability of financial system as a whole. 

This is because CCAR is the binding capital constraint for all of the largest BHCs.  Because they must pass CCAR’s severely-adverse scenarios and the Fed’s qualitative judgment on whether doing so is good enough, big BHCs must manage their portfolios to meet CCAR’s models, not the market.  If they don’t and then flunk CCAR, the Fed restricts capital distributions, investors get mad, market capitalization goes down, and senior-management compensation suffers.  Perhaps bankers should be more altruistic, but none of them got into the business to be philanthropists nor do investors bet on big banks just to be nice.

The reason CCAR exacerbates systemic risk all by itself is the same reason you shouldn’t put all your chips on the same number:  risk concentration.  Because CCAR is the binding capital constraint and because banks must surpass this constraint, banks subject to CCAR do as CCAR directs.  They thus allocate credit not according to their internal judgments about risk or to what the market needs, but instead to what Fed models have magically determined to be the most prudent course. 

This is risky on its own, but even more so when one remembers that CCAR measures only the slices of credit and market risk selected by the Fed, neglecting the liquidity risk that caused the 2008 meltdown in concert with credit strains or the operational risk that has sparked financial crises for decades.  The Treasury Office of Financial Research can tell you more if you’ve the courage to read on about CCAR risk.

But, let’s go on and assume first that banks will step in ahead of the Fed, that economic inequality doesn’t exacerbate systemic risk, and Fed models are indeed magic talismans against risk correlations and other systemic threats.  Even so, the tougher it gets for big banks to undertake a financial activity or price it well, non-banks will do the business without the cost of also doing the Fed’s bidding. 

Call this “shadow banking” if you’re feeling critical or the market at work if not.  Either way, the importance of large non-banks at many systemically-critical linkages in the U.S. and global financial market mean that CCAR is a limited prophylactic now and a doomed one the more it pushes banks out of key businesses.  Think the repo market and be afraid.

CCAR’s Inequality Equation

To ensure that banks can step in when the Fed can’t, the 2018 test not only focuses on cyclically-sensitive credit sectors – i.e., those that rise or fall in relative lockstep with the rest of the economy—but also ramps up loss levels and timing to make adverse stress still more acute.  As an industry assessment of the 2018 round concludes, “…[T]he 2018 scenarios are likely to be particularly stringent for banks that focus on lending to cyclically sensitive sectors, including lending to below-investment grade corporations, small businesses and households with less-than-pristine credit histories.”

Calling CCAR-problematic borrowers those with “less than pristine” credit is kind, but what is really meant here are low-and-moderate income (LMI) households.  Although there are of course less-than-pristine higher-wealth borrowers, the LMI sector has lower credit scores, less savings, and often numerous other obstacles to credit availability that already stymie access to critical loans such as first-time mortgages.

A prior industry assessment of the 2017 CCAR round looked beneath CCAR stress tests to show that small-business and mortgage loans were harshly treated.  Factoring in all the stresses then – let alone those now demanded in the 2018 round – led to de facto capital charges found based on available information to be almost double those required under standardized U.S. capital rules and 45% higher than bank internal models judge for first-lien loans.  For small-business loans, CCAR was then set 80% higher than bank internal models and 200% higher than the U.S. standardized rules.  In sharp contrast, other assets – e.g., consumer loans such as those for credit cards and commercial real estate – score better under CCAR than under either internal models or the Basel standardized approach.  

Which loans would you do?  The ones where you pay a CCAR penalty price or those favored by the Fed’s magic models? 

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