Bank stress tests and enhanced US banking institution standards
Governor Tarullo updates the Senate on Dodd-Frank implementation (Part 5 of 12)
Bank stress tests
Signs of financial stress in Global Systemically Important Banks (or GSIBs)—like Citigroup and JPMorgan (or JPM)—would impact the entire financial system. The signs of stress would impact stocks and bonds (BND). As a result, it’s important that the Fed and other regulators establish a suitable regulatory and supervisory framework. The framework would monitor risks in financial institutions (XLF) (KBE) (KRE).
The Dodd-Frank Act requires large financial firms to conduct stress tests. The stress tests assess whether the firms can withstand a severe economic downturn. The U.S. Federal Reserve conducts an annual Comprehensive Capital Analysis and Review (or CCAR). The CCAR ensures that financial institutions have robust capital planning processes. It also ensures that they have enough capital to continue operations during economic and financial stress. The CCAR includes an assessment of the institution’s sources and how it uses funds. It also looks at liquidity ratios, dividend distribution, and shareholder buyback plans.
As you can be seen from the above graph, returns on financial sector exchange-traded funds (or ETFs)—like the SPDR Financial Select Sector ETF (XLF)—are inversely related to signs of financial stress in markets.
U.S. Fed Governor Daniel Tarullo on the Liquidity Coverage Ratio (or LCR)
“Liquidity standards for large U.S. banking firms are a key contributor to financial stability, as they work in concert with capital standards, stress testing, and other enhanced prudential standards to help ensure that large banking firms manage liquidity in a manner that mitigates the risk of creditor and counterparty runs,” said Federal Reserve Board Governor Daniel Tarullo. He testified before the Senate Committee on Banking, Housing, and Urban Affairs in Washington D.C. on September 9.
The U.S. Federal Reserve and the other U.S. banking agencies approved a final rule. It’s based on enhanced prudential standard requirements in the Dodd-Frank Act—pertaining to U.S. banks’ liquidity requirements. Governor Tarullo spoke about these liquidity requirements for U.S. banks. He said that they were more “stringent” than the Basel Committee on Banking Supervision’s (or BCBS) requirements. We’ll discuss this in the next part of the series. We’ll also look at the major implications for U.S. bond markets.
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