The US Federal Reserve sought to bolster confidence in the US banking system as concerns over the European sovereign-debt crisis roil financial markets and pose risks to the economic expansion.
The Fed on Tuesday told the 31 largest US 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 GDP and a 52 percent plunge in stocks from the third quarter of this year to the fourth quarter of next year.
“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 US firms needed to raise a total of US$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 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 US$43 billion in dividends in 2007 and an additional US$39 billion in 2008, the Fed’s Division of Banking Supervision and Regulation director, Patrick Parkinson, said on June 15.
The goal of the stress test “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 US$50 billion or more are being asked as part of their plan for next year 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.
The Fed is also scheduled to 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 includes 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 institutions the Bank of America Corp, Citigroup Inc, Goldman Sachs Group Inc, JPMorgan Chase & Co, Morgan Stanley and Wells Fargo & Co.
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