By Jon Hill

Law360 (June 19, 2020, 10:40 PM EDT) -- The Federal Reserve Board's top supervision official said Friday that a soon-to-be-released analysis of big banks' performance under several simulated COVID-19 economic recoveries won't be used for setting stress capital buffer requirements but will guide the central bank's thinking on the need for any capital distribution cutbacks.

Speaking to a Women in Housing and Finance online event, the Fed's Vice Chair for Supervision Randal Quarles said the annual stress testing results due to be published on June 25 will include aggregated findings from a "sensitivity analysis" examining how the participating banks might fare if the economy's rebound from the coronavirus pandemic is quick, slow or interrupted.

Although testing run with an older, pre-pandemic scenario will help determine how much capital bigger banks will have to hold in new, risk-sensitive buffers taking effect this year, the additional pandemic-related analysis will "inform our overall stance on capital distributions and in ongoing bank supervision," Quarles said.

"Before the COVID event, over 70% of the capital distributions of global systemically important banks, for example, came in [the] form of share repurchases, which ceased in March," Quarles said in prepared remarks. "The sensitivity analysis will help the board assess whether additional measures are advisable for certain banks or certain future developments."

Quarles' speech comes as the Fed prepares to report on this year's stress testing exercises, which evaluate how well big banks could withstand hypothetical economic turmoil and can affect whether they're allowed to go through with planned dividends and other capital distributions.  

The 2020 tests were also supposed to provide the inputs for the first iterations of the stress capital buffer, a layer of required capital for big banks that would be individually calibrated based on each firm's simulated losses under stress.

But these plans were developed before the COVID-19 crisis, which Quarles said has dealt a sharper blow to employment and growth than is being simulated in this year's stress scenario and has left banks' balance sheets looking materially different from the ones undergoing testing.

Although the Fed announced earlier this spring that the tests would be augmented with additional analysis using "alternative scenarios" meant to reflect the pandemic's impact, there hasn't been much detail about what those scenarios would be or how this analysis would be handled.

In his speech on Friday, Quarles said that the scenarios are built around three hypothetical paths the economy could take out of the depths of the pandemic. Loosely described as V-shaped, U-shaped and W-shaped recoveries, the first two scenarios cover a fast and slow rebound, respectively, while the third contemplates the economy suffering a major setback later this year from a theorized second wave.

Because the scenarios are only "rough approximations," detailed breakdowns of the underlying simulation data won't be available and the balance sheet inputs for each bank have only had "targeted adjustments" to bring them closer to current conditions, Quarles explained.

"Although we didn't run our full stress test on these three possible downside risk paths for the economy, and while our adjustments only capture the most material changes in balance sheets since last year, this sensitivity analysis has helped sharpen our understanding of how banks may fare in the wide range of possible outcomes," Quarles said.

Only high-level findings will be made public, however. Quarles said the Fed won't be disclosing how individual firms performed in the sensitivity analysis but will include aggregated results for each of the three recovery scenarios in the June 25 release, which will also feature the results from both rounds of regular stress testing using the original, pre-pandemic scenarios.

In addition, Quarles said the Fed still plans to provide participating banks with their respective stress capital buffer requirements based on their results under the old stress scenario, even though it has in some respects been overtaken by events.

But Quarles noted it's "roughly the same" as the V-shaped recovery scenario in the sensitivity analysis and said the Fed wanted to "avoid measures that tighten minimum capital levels during a crisis, to avoid intensifying that crisis."

"Should our assessment of the COVID event's likely evolution change, of course, we will act expeditiously to resize the buffer or take other appropriate actions," Quarles said, adding that final requirements won't be publicly disclosed until later this year.

At the Fed, meanwhile, Quarles said the sensitivity analysis results will be used to assess whether banks are equipped with enough capital to weather further potential deterioration in the economy. Big banks entered the COVID-19 crisis with strong capital and liquidity levels, and they have taken precautions as conditions have worsened, according to the vice chair.

"Almost all of our large banks have suspended share repurchases for the second quarter," Quarles said. "In light of the ongoing economic uncertainty, I consider this move for the second quarter a prudent step as a very substantial capital conservation measure."

But he didn't rule out that further efforts may be needed.

"Our use of the sensitivity analysis is an acknowledgement that the path ahead is unusually uncertain," Quarles said. "We will closely monitor the condition of these banks and the broader financial system in the coming months, including through additional COVID-related analysis."

"We will not hesitate to take additional policy actions should they be warranted under the then-prevailing economic conditions," he added.

--Editing by Emily Kokoll.

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