The Federal Reserve told the 31 largest U.S. banks to test their loan portfolios and trading books against a deep recession and a European market shock to ensure they have enough capital to withstand losses.
The most severe test scenarios outlined by the Fed today include an unemployment rate of as much as 13 percent, an 8 percent drop in gross domestic product and a 21 percent plunge in home prices.
The tests may bolster confidence in the nation’s banks by demonstrating they can handle a deeper downturn after a year in which global financial markets were battered by the European debt crisis and U.S. unemployment remained stuck around 9 percent. The Fed helped clear away uncertainty surrounding bank capital adequacy in May 2009, when it published so-called stress tests showing that 10 U.S. banks needed to raise at total of $75 billion, giving investors more clarity on their capital needs.
“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, which includes shares of 24 companies, including Bank of America Corp. and Capital One Financial Corp., is down 31 percent this year, compared with a 5.5 percent decline for the Standard and Poor’s 500 Index.
The so-called Comprehensive Capital Analysis and Review is a centerpiece of the Fed’s heightened oversight of the largest lenders. The aim “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 capital plan review to project revenues, losses and capital positions through the end of 2013 using four different scenarios, two provided by the Fed and two defined by the banks.
“They need to continue to think carefully on their overall capital adequacy and capital actions they’d take including dividend payments and buybacks,” Siddique said.
The reviews will extend from the fourth quarter of 2011 until the last quarter of 2014, taking into account loan-loss reserves at the end of 2013. 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. It said the scenarios don’t represent its outlook for the economy.
The decision to make the scenario 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 stress tests in November last year. The Fed completed those tests in March.
The Fed will also publish the results of the tests for the 19 largest bank holding companies. 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.”
The Fed said it would publish the results of the market shock scenario of the six institutions: Bank of America Corp., 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.”
Ian Katz in Washington at firstname.lastname@example.org.