The Federal Reserve sought to bolster confidence in the U.S. banking system as concerns over the European sovereign-debt crisis roil financial markets and pose risks to the economic expansion.
The Fed yesterday told the 31 largest U.S. banks to test their loan portfolios against a deep recession to ensure they have enough capital to withstand losses. Banks with large trading operations will also test against a European market shock. The most severe scenarios outlined by the Fed include an unemployment rate of as much as 13 percent, an 8 percent drop in gross domestic product and a 52 percent plunge in stocks from the third quarter of 2011 to the fourth quarter of 2012.
“This is a daunting test,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics, a Washington regulatory research firm whose clients include the largest banks. “The Fed’s credibility as a tough guy can’t be challenged based on this.”
The tests, which the Fed said don’t represent its outlook for the economy, aim at making banks’ capital adequacy more transparent by demonstrating whether they can handle a deeper downturn and financial market shock. The Fed helped clear away uncertainty surrounding banks in May 2009, when it published stress tests showing that 10 U.S. firms needed to raise a total of $75 billion, giving investors more clarity.
“Transparency is very important to enhancing global stability,” and “helps with the overall confidence of the banking system,” said Sabeth Siddique, a director at Deloitte & Touche LLP and a former assistant director on the Fed’s supervision and regulation staff.
The KBW Bank Index (BKX) of 24 stocks, including Bank of America Corp. and Capital One Financial Corp., is down 33 percent this year, compared with a 7 percent decline for the Standard and Poor’s 500 Index.
Credit traders are also punishing U.S. banks on concerns of European exposure. The cost of protecting bonds issued by Morgan Stanley (MS) rose 52 percent this month, and for Goldman Sachs Group Inc. (GS) it has climbed by 46 percent. Both are approaching levels reached in the first week of October that were the highest since the failure of Lehman Brothers Holdings Inc., according to data compiled by CMA and Bloomberg.
The Fed aims to prevent the kind of capital depletion that occurred before and during the financial crisis, when firms bought back stock and paid dividends even as their loan portfolios soured and the economy deteriorated.
“One of the central components of prudential regulation is capital adequacy,’ Federal Reserve Governor Daniel Tarullo said in an interview. “We saw in the years preceding the crisis the floodgates open and capital flow out of firms whose ability to weather a storm was actually diminishing.”
The 19 largest banks paid out more than $43 billion in dividends in 2007 and an additional $39 billion in 2008, Patrick Parkinson, director of the Fed’s Division of Banking Supervision and Regulation, said June 15.
The so-called Comprehensive Capital Analysis and Review is a centerpiece of the Fed’s heightened oversight of the largest lenders. The review complies with the Dodd-Frank act’s requirement for annual stress tests and goes beyond it by asking bank boards to devise a strategy for capital management over several quarters.
The goal “is to ensure that institutions have robust, forward-looking capital planning processes that account for their unique risks, and to help ensure that institutions have sufficient capital to continue operations throughout times of economic and financial stress,” the Fed said in a statement.
Bank-holding companies with assets of $50 billion or more are being asked as part of their 2012 plan to project revenues, losses and capital positions through the end of 2013 using four scenarios -- two provided by the Fed and two defined by the banks themselves.
Each Fed scenario for the U.S. variables includes five measures of economic activity and prices, four aggregate gauges of asset prices or financial conditions and four measures of interest rates.
The decision to make the scenarios public before the tests begin marks a step toward greater transparency in supervision by the Fed. The central bank didn’t disclose the scenarios when it started its 2011 capital plan review in November last year. The Fed published them after completing those tests in March.
“To make the stress-testing credible, it is important to be very clear about what the stress assumptions are and to announce some set of the results, including a clear and reasonable plan to build capital if a bank comes up short,” said Randall Kroszner, a professor of economics at the Booth School of Business at the University of Chicago and a former Fed governor.
The Fed will also publish the results of the tests for the 19 largest bank holding companies in late March. Six institutions with large trading operations will have to estimate potential losses from a hypothetical “global market shock,” the Fed said. That shock will be based on market price movements seen during the second half of 2008, it said, and include a scenario involving “sharp market price movements in European sovereign and financial sectors.”
“Given the real concerns about Europe, it is prudent to make sure that bank management has thought through how they would deal with such a shock,” Kroszner said.
The Fed said it would publish the results of the market shock scenario of the six institutions: Bank of America Corp. (BAC), Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley and Wells Fargo & Company.
“This is a massive amount of information they will give to markets to judge the quality of banks,” said Doug Landy, a partner at Allen & Overy LLP and a former New York Fed attorney.
The Fed said it would approve dividend increases and other capital distributions “only for companies whose capital plans are approved by supervisors and are able to demonstrate sufficient financial strength to operate as successful financial intermediaries under stressed macroeconomic and financial market scenarios.”
Fed Chairman Ben S. Bernanke and his colleagues this month cut their growth forecasts for 2012 and said unemployment will average 8.5 percent to 8.7 percent in the final three months of next year, up from a prior range of 7.8 percent to 8.2 percent.
“While recent incoming data suggested reduced odds that the economy would slide back into recession, participants still saw significant downside risks,” according to minutes of the Nov. 1-2 meeting, released yesterday. “Risks included potential spillovers to U.S. financial markets and institutions, and so to the broader U.S. economy, if the European debt and banking crisis were to worsen significantly.”
The capital plan reviews and stress tests have inserted the Fed into decisions normally reserved for banks’ boards of directors. Executives at some of America’s biggest financial firms have bristled at the intrusion.
“I think it is important to point out that the board is responsible for this company, not just the regulators,” Dimon responded. “It is still America. Capitalism is still alive.”
“If regulators start making all the capital decisions, then they should be on the board,” Dimon said, according to a transcript of the July 14 conference call.
Ian Katz in Washington at email@example.com.
To contact the editor responsible for this story: Christopher Wellisz at firstname.lastname@example.org