Surprise! Stress Test Methods Not so Surprising

The Federal Reserve today detailed the process and methodologies used in the bank stress tests under the Supervisory Capital Assessment Program. For all the hype the anticipated announcement created, the actual methodologies reported came as no substantial surprise, as actual stress test results have yet to circulate but are expected for public release May 4. The Fed did announce, however, that most US banking organizations currently have capital levels well in excess of the amounts required to be well capitalized. “However, losses associated with the deepening recession and financial market turmoil have substantially reduced the capital of some banks,” the Fed warned in its statement on the process. Regulators required all US bank holding companies with year-end ’08 assets exceeding $100bn to participate in the assessment, which began February 25. These 19 institutions collectively hold two-thirds of the assets and more than half the loans in the US banking system, according to the Fed. More than 150 examiners, supervisors and economists from the Fed, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation studied banks’ potential performance under projected economic expectations and a more adverse outlook with a longer, more severe recession. The point: to determine the capital buffer needed to ensure the firms would remain appropriately capitalized at the end of 2010 if the economy proves weaker than expected. The “extensive” process, as described by the Fed: 1. Banks first submitted projected losses on a variety of loan categories to the government. 2. Federally appointed supervisors then evaluated the “substance and quality” of banks’ projections and requested additional data, if necessary. 3. Supervisors developed independent benchmarks for each firm based on its portfolio characteristics. 4. Supervisors used banks’ benchmarks to determine bank performance under more adverse conditions. 5. Senior supervisory officials finally determined the banks’ necessary capital buffer to “continue to play their critical roles as intermediaries” under either scenario. The Fed said supervisors conducted calculations under regulatory and accounting frameworks present as of year-end ’08, which require bank holding companies to generally hold a dominant share of their regulatory capital in the form of common equity. If banks cannot raise enough capital, of course, the Treasury Department has committed to either supply more federal funds or exchange existing preferred stock purchased through the Capital Purchase Program for common shares. The latter option would create some degree of government ownership, however, that may likely affect consumer and investor confidence in the banks. Read the Fed’s white paper on the process. Write to Diana Golobay at [email protected].

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