Fed Tells U.S. Banks to Test Capital For Recession Scenario

The Federal Reserve ordered the 19 largest U.S. banks to test their capital levels against a scenario of renewed recession with unemployment rising above 11 percent, said two people with knowledge of the review.
The banks stress-tested the performance of their loans, securities, earnings, and capital against at least three possible economic outcomes as part of a broader capital-planning exercise. The banks, including some seeking to increase dividends cut during the financial crisis, submitted their plans last month. The Fed will finish its review in March.
“They’re essentially saying, ‘Before you start returning capital to shareholders, let’s make sure banks’ capital bases are strong enough to withstand a double-dip scenario,’ ” said Jonathan Hatcher, a credit strategist specializing in banks at New York-based Jefferies Group Inc. Regulators don’t want to see banks “come crawling back for help

Dodd-Frank Act

The Fed also wants banks to consider how the Dodd-Frank Act overhauling financial oversight might affect earnings, and how they will meet stricter international capital guidelines, according to the November notice. Banks will also have to consider how many faulty mortgages investors may ask them to take back into their portfolios. Standard & Poor’s Corp. estimates mortgage buybacks could cost the industry as much as $60 billion.
The Fed’s adverse economic scenario included a 1.5 percent decline in gross domestic product from the fourth quarter of last year through the end of 2011, said the people, who declined to be named because the Fed hasn’t made the details of the review public. The scenario assumed growth resumes, with output rising 4 percent over the fourth-quarter 2010 level by the end of 2013. Unemployment would peak at more than 11 percent by the first quarter of 2012 and drop back to 9.5 percent by the end of 2013.
Federal Reserve spokeswoman Barbara Hagenbaugh declined to comment on the specifics of the Fed’s parameters.

Growth Outlook

While Fed policy makers want banks to be prepared for a slump, they aren’t predicting one. In January, members of the Federal Open Market Committee forecast growth of 3.4 percent or more annually over the next three years, with the jobless rate falling to 6.8 percent to 7.2 percent in the fourth quarter of 2013. Unemployment averaged 9.6 percent in the final three months of 2010.
As part of the most recent capital exam, regulators have made one of the largest data requests in Fed history, outside of normal regulatory reporting, asking banks for information about their securities, loans and other holdings. This will give the Fed the ability to check and even challenge the assumptions banks make about their portfolios.

Financial-Risk Unit

The tests are being overseen by a new financial-risk unit assembled by Chairman Ben S. Bernanke and Tarullo. Known as the Large Institution Supervision Coordinating Committee, or LISCC, the unit draws on the Fed’s deep bench of economists, quantitative researchers, regulatory experts and forecasters and looks at risks across the financial system. The LISCC last year helped Bernanke respond to an emerging liquidity.

100 Fed Staff

The dividend increases, if they happen, will be one of the most carefully screened payouts in U.S. regulatory history, with more than 100 Fed staff working on the capital analysis of the banks.
Congress is also watching. The Fed should be cautious about allowing banks to reduce their capital through dividends or stock repurchases, House Democrats, including Representative Brad Miller of North Carolina, said in a Feb. 15 letter to Bernanke.
“We applaud your undertaking new stress tests on the banks,” the lawmakers said. “It appears doubtful, however, that the stress tests alone can resolve the uncertainty facing those banks to justify reducing their capital.”
The Fed’s involvement in decisions normally reserved for boards shows how far the Dodd-Frank Act has pushed regulators into corporate governance.
“It is an uneasy balance between regulating an institution and running it,” said Karen Shaw Petrou, managing partner at Federal Financial Analytics in Washington, a research firm whose clients include the nations’ biggest banks. The Fed is moving “far more assertively” on bank oversight, she said.

2009 Stress Tests

As with the 2009 stress tests conducted by the Fed during the crisis, one of the goals is to assure that bank capital can support new loans to creditworthy borrowers. Loans and leases of banks in the U.S. contracted at a 10.3 percent annual rate in 2009, a 6.2 percent rate in 2010, and at a 2.6 percent rate in January.
The Fed’s unprecedented exam of the 19 largest lenders in May 2009 concluded that 10 U.S. banks needed to raise an additional $74.6 billion in capital.
Banks were “destroying” value when they repurchased billions of dollars of stock in the years leading up to 2008, only to issue shares later at lower prices after they needed capital amid the crisis, said Jefferies Group’s Hatcher, a former bank examiner for the Federal Deposit Insurance Corp.
“Whether it is liquidity, capital or earnings, banks are on a much better footing than they were a couple of years ago,” said R. Scott Siefers, managing director at Sandler O’Neill & Partners LP in New York, a brokerage and research firm specializing in financial companies. “Still, you can pick your caveat. We are only in the early stages of an earnings recovery on the lending side and the legislative and regulatory framework is still in flux.”
Read entire article at Bloomberg.com