Banks Stressing Out About Stress Tests

WASHINGTON — The largest U.S. banks are bracing for the release of stress test results this week by the Federal Reserve Board — and the stakes have seldom been higher.

The test, which bank executives describe as a "very taxing" exercise given the reams of financial documents and calculations they provide to the Fed, will determine what firms can pay a dividend to shareholders, and it will likely shape public perceptions of the health of the institution.

"If a bank fails the test, or does not get approval for what it hoped to get, the negative could be the market reaction to that specific bank," said Joseph Pucella, senior bank analyst for Moody's Investors Service. "From a credit perspective, if a bank does not meet the Fed's capital requirements under the stress test, then it's a good thing that the bank will be restricted from increasing its dividend. At the same time, the market could have a negative reaction if the bank is singled out as a weaker player."

Without much public notice, the Fed met in a closed meeting Thursday to discuss the stress test results. It is expected to release the data by March 15.

Banks have had to undergo stress tests before, but this round marks the first time since the financial crisis that the results will be made public — and it is arguably the most severe version of the test, given the harsh variables that banks had to score themselves against.

"This time around the scenarios were much harsher," said Sabeth Siddique, a director at Deloitte & Touche LLP and a former assistant director of banking supervision and regulation at the Fed. "And that's in part due to the continued uncertainty in the economic environment as well as some of the potential spillover effects from Europe."

Those variables included projecting a bank's condition if unemployment jumped to 13% (it is currently at 8.3%), the Dow Jones Total Market Index fell to 5,700 points and a sharp decline of gross domestic product to minus-8%.

While those variables must be tested by the 19 largest banks, the six biggest must go even further.

Companies like Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. have to run a global market shock scenario that replicates similar events that occurred during the second half of 2008.

Privately, some bank executives are worried about the number of adjustments the Fed will make to the numbers provided by the banks — changes the banks may not see until just before they are made public.

"It's a little disconcerting somebody is going to publish something about you and you don't know about it, and get to study it and figure it out beforehand," said an executive from a large bank. "They're not really sharing that with us much before they go public with the numbers that embed those adjustments."

In many ways, the current environment is reminiscent of 2009, when the Fed initially released details about firms' stress tests. At the time bankers and analysts worried that the results could tip some weaker institutions over the edge, or potentially aggravate fears about the strength of the financial system. Instead the results helped to restore confidence in the banking system.

But the Fed declined to provide the same level of detail last year when it completed the first round of stress tests postcrisis, citing a lack of data to compare it against.

This time the Fed is expected to release information similar to its 2009 round, but it may go even further. A spokeswoman declined to provide details.

The industry may know more shortly. The last time results were unveiled, the Fed released a paper outlining its methodology as well as a statement from regulators a few days in advance — a scenario that may bear out this time.

Banks are not just concerned about the appearance of stability, however. Many are worried that the data may give competitors insight into their business model.

"We're in an environment where we are not in a financial crisis, and the Fed's decision to disclose stress test results on a more consistent basis. Banks are now worried about what kinds of information could be disclosed that compromises their competitive advantage over the other," said Siddique said.

Given the time horizon — the fourth quarter of 2011 to the fourth quarter of 2014 — banks fear that market analysts will have an easier time guessing an institution's capital action plan and potentially what its net income will be in the future. "You're giving the marketplace a lot of information it didn't necessarily have before and is typically not given," said one bank executive.

In its instructions to firms from last November, the Fed said it will disclose each bank's capital ratios, such as leverage and Tier 1 common ratios, as well as the minimum value of these ratios on a quarterly basis through the fourth quarter of 2014. It also said it would release information about stress loss projections and loss rates for major loan categories.

The Fed has said it is important to provide the public with more information. "The disclosure of stress test results allows investors and other counterparties to better understand the profiles of each institution," Fed Gov. Daniel Tarullo told bankers in a November speech. "And, I believe, the demands of supervisors for well-specified data and projections from firms has improved risk management at these institutions."

In recent weeks banks have pressed the Fed to disclose significantly less information, even though the Dodd-Frank Act calls for even greater disclosure. Earlier this month the Clearing House wrote a letter urging regulators to limit the information disclosed to the public to what was released under the first stress testing exercise in 2009 in order to provide an opportunity to those looking to comment on the appropriate scope of disclosures of the test.

But Dodd-Frank calls for a different round of annual stress tests, ones that must be conducted by the banks themselves, instead of being completed by the Fed off of bank data. Under a proposal issued last year, banks would be required to publish a summary of their company-run stress test results, including data on capital ratios, and losses on loans, securities and trading portfolios.

Banks worry they will ultimately be required to provide the same level of detail about their own internal stress tests, which are required by Section 165 of the Dodd-Frank Act, as the Fed releases to the public next week. "If the Fed commits itself to a level of disclosure under CCAR [the Comprehensive Capital Analysis and Review] that's very difficult for them to walk back that paradigm of disclosure under 165," said another large-bank executive.

The central bank has not explained in detail yet how it plans to incorporate its annual stress testing with the new requirements under Dodd-Frank, only saying it will be "an important component" of its yearly review of the bank's capital planning.

The 19 firms will also have to provide a transition plan detailing their ability to meet capital requirements set forth under Basel III. Those banks that remain below the 7% Tier 1 common equity target will be expected to maintain prudent earnings retention policies with the goal of meeting that target.

"They wanted to understand how long each bank would take to meet those Basel III ratios, if they're not meeting them already," said Siddique. "Many institutions are already meeting them and maintain them under stress conditions. So the Fed wanted to understand if they are not meeting them now, how long would they take to meet them under the baseline scenario."

For the eight banks that will likely face an additional capital surcharge between 1% and 2.5% under the Basel III rules, those institutions will have to give the company's best estimates of their likely surcharge and show their ability to meet those ratios "readily and without difficulty" through 2016.