The Federal Reserve's new stress test to determine large banks' capital buffers, which will go into effect in 2027, significantly shortens the liquidity horizon in which it believes banks will be able to sell securitized products in times of stress.
The change could increase demand from investors in securitizations and lower costs for issuers, while increasing market risk in times of prolonged stress.
Regulators significantly increased the capital requirements for riskier assets of large banks in the wake of the Great Financial Crisis (GFC), prompting them to reduce their inventories of securitized assets.
The Federal Reserve proposed new stress test standards last October, which it finalized February 4. After implementation in 2027, the standards will shorten the liquidity horizon to three months from 12 months. The reduction assumes banks will be able to sell the illiquid securities much faster, reducing the capital they must hold against them.
The change enables large banks to increase their inventories of securitized products and make markets in them, increasing their liquidity.
That should tighten the securities' bid/ask spreads and increase the depth of those markets, enabling more trading and potentially larger trades, said Til Schuermann, global head of finance and risk at Oliver Wyman. More liquidity, in turn, could attract new investors whose liquidity requirements previously excluded those types of securities.
The flip side
The new liquidity horizon does carry a major caveat, involving extended periods of volatility.
"The problem occurs if there is a very severe shock," Schuermann said, adding that the point of the stress test is to prepare banks' capital buffers to weather an extreme-shock scenario. "So if we get this wrong, and the new, shorter liquidity-horizon shock scenarios underestimate the severity of actual tail-risk events, that's a bad outcome."
Even so, Schuermann said, regulators had maintained hefty capital requirements instituted in reaction to the GFC that steered regulated banks away from illiquid bonds. Consequently, less regulated, often proprietary trading firms have stepped in to fill the breach, potentially increasing systematic risk.
For some illiquid products, the Fed may be relaxing some of the shock severity a bit too aggressively.
The liquidity horizon, however, makes no distinction between mildly and highly liquid securitizations. For example, the typically illiquid mezzanine tranches of collateralized bond obligations (CLOs) are treated the same way as liquid AAA CLOs from a liquidity-horizon-under-stress perspective.
"The bottom line is that for some illiquid products, the Fed may be relaxing some of the shock severity a bit too aggressively," Schuermann said.
Alla Gil, CEO of Straterix, said that the Fed's Comprehensive Capital Analysis and Review (CCAR) program, also prompted by the GFC, provides a separate tool for the regulator to measure the adequacy of banks' capital to withstand stress periods in the form of instantaneous global market shock (GMS). She noted that the shorter liquidity horizon could incentivize impacted banks to expand their inventories of securitized products, increasing liquidity and tightening spreads. The extent of the impact is debatable, however.
Since the shorter liquidity horizon will be applied to just eight very large banks subject to the Fed's GMS test, she said, "I'm not sure if the capital reduction in a few banks for just one GMS component will have a visible impact."
Holding off finalization
When the Fed announced finalizing the hypothetical scenarios to use in its annual stress test, it added that the board voted to maintain the current stress capital buffer requirements until 2027.
"Waiting to calculate new stress capital buffer requirements until we receive public feedback will give us the opportunity to correct any deficiencies in our supervisory models based on that feedback," said Vice Chair for Supervision Michelle W. Bowman.
Schuermann noted that depending on the results of a scenario, market participants may draw different conclusions: if capital erosion is more than it was last year, banks should be holding more capital; and vice versa.
"It'll be a signaling mechanism, but it won't change anything this year in terms of capital requirements," Schuermann said.
