A group of U.S. bankers that advises the Federal Reserve urged supervisors last month to reduce the “uncertainty and confusion” posed by the most recent test of banks’ ability to weather financial turmoil.
Members of the Federal Advisory Council, including Vikram Pandit, Citigroup Inc.’s chief executive officer, said the uncertainty was generated by the “significant differences” between the analysis used by the Fed in its stress-test models and those used by participating banks, said the memo describing the May 11 meeting released today by the Fed.
“Those disparities place bank boards in a highly vulnerable position,” the memo said. “Board members are literally compelled to ‘fly blind,’ in effect guessing about high-stakes capital distribution decisions that can tip the balance between the success of passing” the stress test and “the market punishment associated with failure.”
Tension between banks and regulators has grown as agencies begin to implement new rules under the Dodd-Frank Act requiring banks to raise capital, curtail risk and rein in compensation. The Fed in March completed its most recent stress test, which it calls the Comprehensive Capital Analysis and Review, and published its own test results for the 19 largest U.S. financial institutions.
Bankers complain that the stress test is awkward for boards, which have to approve capital distributions before the Fed gives final approval to such decisions. The Fed can overrule a board if it thinks a bank needs a higher capital buffer.
The KBW Bank Index, which tracks 24 large U.S. and regional banks, fell about 1.6 percent to 42.93 at 2:08 p.m. in New York. The Standard and Poor’s 500 Index fell 0.6 percent to 1,318.98.
Fed Governor Daniel Tarullo, who attended the May meeting along with Chairman Ben S. Bernanke and Vice Chairman Janet Yellen, said in April that the Fed would consider “both substantive and procedural improvements” in the stress-test process.
“Over the coming months we will be consulting extensively with academics, other analysts, and the banks themselves,” Tarullo said in an April 10 speech in Chicago. “We are forming an advisory group of academics and other experts to advise our internal model-validation team on an ongoing basis.”
The bankers complained that Basel III liquidity requirements would result in banks selling holdings of government agency securities and reducing certain deposits by as much as $1 trillion. They said the proposed liquidity ratios create an incentive to hold government securities even if other assets are more liquid and carry less risk.
The Fed on June 8 proposed capital rules under the terms of Basel III. The regulators didn’t include liquidity rules agreed to by Basel two years ago and are reworking them for a later release.
The bankers said some aspects of U.S. and global regulatory reform “could add to the risk of spillover and contagion effects.” They complained that a “consistent bias” against non-U.S. sovereign debt could disrupt “global efforts to mitigate systemic risk.”
Regulators have exempted U.S. government debt from regulations such as the Volcker rule limit on proprietary trading and the single-counterparty credit limits while not extending such loopholes to non-U.S. sovereign debt.
The bank executives also cited a growing and “unnecessary tension” between the Fed’s goals on compensation and those of shareholders.
“It is commonly perceived that performance goals will be subject to supervisory criticism unless they are highly achievable and avoid rewarding exceptional performance,” the memo said. “Shareholders, however, rightfully want to encourage exceptional effort and corresponding performance, and doing so should not be viewed as inconsistent with safety and soundness.”
The bankers said as a result of previous conversations with the Fed that they have already increased their amount of deferred compensation, incorporated performance-based vetting features and improved the governance framework for determining compensation.
The council meets four times a year and includes one banker from each of the Fed’s 12 districts. Current members include Citigroup’s Pandit; James Rohr, chairman and chief executive officer of PNC Financial Services Group; and Richard Fairbank, chairman and CEO of Capital One Financial Corp.
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