Fed to Test Banks for Interest Rate Rise, Housing Collapse

The Federal Reserve said it will examine how the biggest banks might react to a jump in long-term interest rates and another housing crash as it released the next round of stress-test scenarios designed to monitor the ability of the U.S. financial system to withstand economic shocks.

The central bank mentioned that as part of two adverse scenarios it will gauge bank resilience against declines in the prices of high-risk, high-yield loans and debt and some high-priced real estate markets around the country, according to a statement released in Washington today. The central bank also inserted a test for large trading and clearing banks on counterparty default.

The Fed is using the tests -- based on hypothetical adverse conditions and not forecasts -- to encourage the 30 biggest banks to build capital cushions against economic turmoil. The central bank said 12 of the banks will be subject to the capital review for the first time.

“The aim of the annual reviews is to ensure that large financial institutions have robust, forward-looking capital planning processes that account for their unique risks, and to help ensure that they have sufficient capital to continue operations throughout times of economic and financial stress,” the Fed said in the statement.

Risk-Weighted Assets

The 18 bank holding companies tested previously have increased their aggregate tier 1 common capital to $836 billion in the second quarter of 2013 from $392 billion in the first quarter of 2009, the Fed said in a press release. Their tier 1 common ratio, which compares capital to risk-weighted assets, has more than doubled to a weighted average of 11.1 percent from 5.3 percent, the Fed said.

The six banks with large trading operations will be required to test how their portfolios would perform against a global shock to financial markets. They are Bank of America Corp., Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley and Wells Fargo & Co. The Fed will release the details of that scenario “soon” according to the release.

Those banks, as well as Bank of New York Mellon Corp. and State Street Corp. will also have to test against a scenario in which one of their counterparties experiences an “instantaneous and unexpected” default. This test was designed to see if banks could withstand the failure of their largest counterparties, unlike previous tests which focused on incremental defaults as the economy eroded, a Fed official said on a conference call with reporters.

Too Heavily

The test suggests Fed officials remain concerned that banks might still rely too heavily on single or weak counterparties to hedge potential losses on assets and other commitments, a trend that contributed to the 2008 financial crisis. Banks have argued in past years that they can mitigate risks by purchasing protection such as credit-default swaps from counterparties.

Goldman Sachs and other firms had purchased protection from New York-based insurer American International Group Inc., allowing them to subtract the CDS on their books from their reported subprime mortgage debt holdings.

When prices of mortgage securities started falling in 2008, AIG was required to post more collateral to its CDS counterparties. It ran out of cash doing so, and the U.S. government took over the company. If AIG had collapsed, what the banks saw as a hedge of their mortgage portfolios would have disappeared, leading to billions of dollars in losses.

Credit Risk

The Fed, seeking to reduce the chance that one failing company would topple others, proposed in December 2011 to cap how much counterparty credit risk a bank could have with any systemically important trading partner. The limit would be 10 percent of regulatory capital.

The proposal has been stuck in limbo without being finalized after heavy lobbying by banks. JPMorgan, Citigroup and Morgan Stanley were among lenders arguing that the limit was poorly constructed, overstated risk and would restrain the economy. It could cut U.S. economic growth and destroy 300,000 jobs, Goldman Sachs warned last year.

The Office of the Comptroller of the Currency released a parallel set of scenarios today for national banks and federal savings associations above $10 billion to follow in their “company-run” testing. As in the Fed version, the OCC also set hypothetical baseline, adverse and several adverse conditions for the exercises.

First Test

The Fed conducted its first stress test in 2009 to promote transparency over bank assets and determine their potential losses in an adverse economy. Confidence in banks was low because portfolios were opaque, capital was scarce and job losses were rising during the worst recession since the Great Depression.

After the test, 10 of the 19 largest banks were required to raise $75 billion in total equity capital.

Since then the tests have evolved into an exercise in forward-looking capital planning. The Fed’s Comprehensive Capital Analysis and Review will examine how risk management and governance policies at the largest banks shape dividend and share buyback policies.

The Fed in August released a report that criticized the largest banks for falling short in at least one of five areas deemed critical to risk management and capital planning. These included “generating projections for at least some components of loss, revenue, or expenses using approaches that were not robust, transparent, and/or repeatable.”

Stocks Rise

The KBW Bank Index, which tracks shares of 24 large U.S. banks, is up more than 25 percent this year compared with a 23 percent gain for the Standard and Poor’s 500 Index.

In the “severely adverse” scenario, the unemployment rate peaks at 11.25 percent, stocks fall nearly 50 percent and U.S. housing prices decline 25 percent while the euro area also sinks into recession. Developing economies in Asia also experience a “sharp slowdown,” the Fed said.

In an “adverse” scenario, banks will be tested against global flight from long-term debt that pushes the U.S. economy into a recession, with unemployment rising to 9.25 percent. The yield on the U.S. 10-year Treasury note jumps to 5.75 percent by the end of 2014, and corporate bond and mortgage rates also rise.

“The biggest concern for banks today, which is the risk of rising interest rates, aren’t stressed well enough in these tests,” said Chris Whalen, managing director at Carrington Holding Co. LLC in Greenwich, Connecticut. “When rates rise, liquidity will diminish a great deal as well and the tests are assuming constant liquidity.”

Larger Decline

The Fed said in an outline of the tests that the larger decline in U.S. house prices in this year’s severely adverse scenario is “particularly relevant for states or metropolitan statistical areas that have experienced brisk gains in house prices over the past year.”

The wider corporate borrowing spreads featured in both tests are “intended to represent a corresponding widening in spreads across all corporate borrowing rating tiers and instruments, particularly those instruments -- such as high-yield corporate bonds and leveraged loans -- that are at present experiencing particularly narrow spreads,” the central bank said.

The test was designed in part to build resiliency in the financial system against what some would define as emerging bubbles, according to a Fed official who spoke on the conference call with reporters.

Early January

Companies will have until the first week of January to submit their capital plans, and the results will be released in March.

This year, the Fed will reveal how banks fare under both scenarios. Previously the central bank did not disclose the results in the scenario that included rising interest rates.

The eight banks with more complicated scenarios have been through the Fed’s stress test and capital planning process before, as have Ally Financial Inc., American Express Co., BB&T Corp., Capital One Financial Corp., Fifth Third Bancorp, KeyCorp, PNC Financial Services Group, Inc., Regions Financial Corp, SunTrust Banks, Inc., and U.S. Bancorp.

Twelve banks will be participating in the process for the first time. Those banks are BMO Financial Corp., BBVA Compass Bancshares, Inc., Comerica Inc., Discover Financial Services, HSBC North America Holdings Inc., Huntington Bancshares Inc., M&T Bank Corp., Northern Trust Corp., RBS Citizens Financial Group, Inc., Santander Holdings USA, Inc., UnionBanCal Corp., and Zions Bancorp.

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