Key topics
- Banks sue the Fed, challenging opaque stress-test methods.
- Goldman Sachs highlights a $8B gap in capital optimization due to Fed errors.
- Industry seeks recalibration of outdated capital surcharges to free up billions.
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By Marc Rubinstein ___STEADY_PAYWALL___
Banks are used to fending off litigation. Goldman Sachs Group Incâs most recent annual report includes 14 pages of fine print detailing all the proceedings it faces. But defendant has turned plaintiff. On Christmas Eve, bank trade groups filed suit against the Federal Reserve, arguing that its annual stress-testing process violates the principles of the Administrative Procedure Act.
Banks have complained about regulatory overreach before; now, encouraged by an increasingly friendly legal environment, theyâre bringing the issue to the courts.
âFor the industry, the bar to take this step was incredibly high,â explained Goldman Sachs Chief Executive Officer David Solomon on his earnings call last week. âWe believe it is our responsibility to continue to press for a more transparent regulatory process in order to foster a more efficient financial system that supports growth and competitiveness of the US economy.â
Like other industry executives, Solomon has been frustrated by regulatorsâ approach to capital. On top of a basic threshold, authorities require acushion tailored to banksâ individual circumstances. One of these buffers is determined by an annual stress test conducted by the Fed. The problem, according to banks, is that this stress test is âadopted in secretâ and produces âvacillating and unexplained requirements and restrictions on bank capital.â
Goldman Sachs is particularly implicated. Last year, the Fed projected that the firmâs capital ratio would slip to 8.5% under a severely adverse economic shock, down from 14.4% at the time it conducted its exercise. The Fed shares its top level assumptions with banks â home prices dropping 36%, unemployment surging to 10%, equities crashing by 55%, that sort of thing â but keeps detailed modelling to itself. No surprise such a shock should deplete so much capital. But when Goldman replicated the process, it couldnât get close. Based on its calculations, its capital ratio would drop to only 10% in such a scenario.
The Fed didnât burnish its credentials when it admitted it made an error. Since 2020, it has allowed banks to dispute stress tests and although eight have tried, so far only Goldman has succeeded. In a letter to Solomon in August, the Fed conceded that it shouldnât have rolled forward some one-off costs. It revised up the firmâs worst-case capital ratio to 8.8%.
But that still leaves a gap, which the court challenge is designed to address. The industry is demanding greater transparency in the way the Fed runs its tests. A win would enable banks to optimize their balance sheets more effectively, allowing them to free up capital. If Goldmanâs internal test serves as a proxy, capital release could amount to around $8 billion at the firm.
As well as bringing this case, banks are also seeking relief from another of the capital conservation buffers that regulators impose. Global, systemically important banks like Goldman Sachs are subject to a surcharge that reflects, among other factors, their size, complexity and interconnectedness. But this surcharge hasnât been recalibrated since 2015. Even the Fed admits that risk scores should be adjusted to account for inflation and economic growth. Under current rules, Goldman Sachs is on course for a 3.5% surcharge. A reduction to 2%, for example, would release another $10 billion of capital.
Even before any changes, capital policy was becoming more bank friendly. The so-called Basel 3 Endgame aimed at completing the post-crisis framework that capital conservation buffers operate in was first watered down and then left in limbo when its steward, Fed Vice-Chair Michael Barr, announced this month that he would step down. âGiven the change in administration and the change of leadership inside the Fed, our expectation would be that there’ll be a different approach than what has been put forward,â commented Solomon on his recent earnings call.
Since the global financial crisis, levels of high-quality capital at banks have increased by over 3.5 times, according to the Bank Policy Institute, one of the trade groups that brought the case. At Goldman Sachs, the capital ratio has risen to 15.4% from 8.2% in 2010. With over $100 billion of capital now sitting on his balance sheet, Solomon will be starting to think about how he can deploy any excess that comes his way.
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