Fed Raises the Bar on Stress Tests

WASHINGTON — Banks are going to have to work harder next year if they want to continue to pass the Federal Reserve Board's annual stress test exercise.

As JPMorgan Chase & Co., Goldman Sachs and BB&T learned firsthand last week — when the central bank released its latest stress results of the 18 largest banks — it's not always just about how much capital a firm is projected to hold. All three banks ostensibly scored well on the test, holding capital above the minimum 5% Tier 1 common ratio even in a "severely adverse" economic scenario.

But those banks were also criticized for their ability to effectively estimate how a particular risk might affect their portfolio and required to draft new capital plans as a result.

"This is a strong warning to the market and the banks that the Fed is expecting incrementally better risk management systems each year," Jaret Seiberg, a senior policy analyst for Guggenheim Partners' Washington Research Group, wrote in a note to clients. "Banks that fail to improve will not pass the test regardless of their stress test performance."

The Fed this time around utilized a third alternative beyond pass or fail — a purgatory for capital plans. Banks could pass the test, but still need to do extra work on their capital plans, which would later be evaluated by the Fed. In the case of JPMorgan and Goldman, both were asked by the Fed to submit new capital plans by the end of the third quarter to address weaknesses in their planning process. (The Fed can object to both revised plans, if it's still not satisfied with the changes.)

A senior Fed official said on a conference call with reporters that there were certain deficiencies in both of the firm's capital planning process that were significant enough to warrant immediate fixes, rather than waiting for the next round of stress testing.

BB&T, meanwhile, actually failed the test, despite holding a Tier 1 common ratio of 7.76% in an adverse economic scenario, well above the minimum. The Fed said the bank fell short because of "qualitative" reasons, dramatically underscoring the importance of risk management.

"We have argued for a year that the qualitative factors of the capital planning process mattered more than the actual performance on the CCAR stress test," Seiberg wrote. "The Federal Reserve drove that point home by rejecting BB&T's distribution on qualitative grounds and requiring JPMorgan and Goldman Sachs to immediately remedy capital planning weaknesses in order to win approval to distribute capital."

Neither the Fed nor BB&T have elaborated on the "qualitative" factors that caused that judgment. However, a footnote in the results released from a separate round of stress tests required by the Dodd-Frank law, offers some explanation. BB&T made changes to its risk-weighted assets, which it publicly disclosed, in order to meet regulatory standards, but by doing so caused a decrease in the bank's risk-based capital ratios.

BB&T's stress test failure has created even more uncertainty about a process that has already been heavily criticized for lacking transparency.

Prior to this year's test, banks may well have believed that their success or failure would depend on if they could maintain a 5% Tier 1 capital ratio over a nine-quarter time horizon — but that is definitively no longer the case. Going forward, banks will recognize they must also comply with qualitative measurements that may also be unclear.

"Frankly, it increases the uncertainty," said Hugh Conroy, a partner at Cleary Gottlieb Steen & Hamilton. "If I don't know what it is that the Fed doesn't like until they actually tell me, I may have run all my numbers and thought I was doing perfectly well and then it turns out that the Fed even though they gave me some preliminary indication my numbers were good. I find out my processes aren't good enough."

Only one bank lodged a public complaint on the stress tests this year: Ally Financial, which also failed the test because its projected capital fell to 1.52%, well below the minimum. The rest of the banks released a flurry of scripted public statements that were largely positive.

Still, there remains continued frustration among banks over the Fed's lack of transparency in disclosing its models and assumptions. (On the call, the senior Fed official said regulators plan to keep such information secret, so no institutions can study for the test.)

"They all immensely dislike this dividend, share buyback system. But what banker can speak out for fear that the Fed will punish them?" said Ernest Patrikis, a partner with White & Case and former general counsel of the New York Fed.

In a possible sign of its frustration, American Express, which was one of two firms to resubmit its capital plan after it initially fell below the 5% threshold, made note of the discrepancy between its results and those of the Fed. Based on its internal analysis, American Express projected that it would hold 9.2% in Tier 1 capital in an economic downturn, but the Fed's estimate was far lower, yielding 4.97%.

The Fed's projected cumulative loan loss provisions were also $3.1 billion above the company's own estimates, and $4.6 billion higher than the Fed's analysis last year.

"As indicated in the Federal Reserve report published last week, some of the Federal Reserve's models used in this year's analyses changed substantially or were newly implemented," according to American Express' statement.

American Express submitted a new capital plan, yielding a final projection of 6.42%, enabling it to pass the Fed's test. (Ally, the other bank to retake the test, actually fared worse the second time.)

The experience demonstrates banks' lack of insight into the Fed's process.

"For example, American Express said in their press release that the Fed said that there were model changes from last year and the Fed does not disclose to us how their models changed or how their models work," said Conroy. "You could see in that press release a little bit of frustration. There's still some confusion by the banks. Yes, we passed, but if we made one wrong move adding another cent to our dividend, we might not have passed."

Still, some observers said that while further cooperation is necessary, the process has become more transparent, not less.

"The banks are working more closely with the regulators in trying to get this right from their point of view," said Patrick Sims, a senior analyst with Hamilton Place Strategies. "There probably needs to be increased work together on that front. As you saw with some of the valuation models of the various banks that they didn't think the stress scenarios affected their balance sheets as much the Fed did, so that's a promising thing that the Fed is being more conservative with their estimates, estimating bigger losses. If you're a regulator, and you've just gone through the crisis, that's probably a pretty smart to do."

Discrepancies between regulators and the banks should not be a cause for alarm, observers said.

"Everyone has their own models," said Patrikis. "It's just like their own models for evaluating assets. There's nothing wrong with that. There's nothing wrong with them being different. The Fed goes in as a supervisor and will be looking at those models and will be testing those models and that will help assure that the models are sufficiently rigorous, and that is certainly a legitimate role of the Fed."

Some analysts said that policymakers should be more worried about how long the Fed plans to use the tests to approve banks' capital plans.

"Who's running the bank? What kind of program is this?" said Patrikis. "The Fed ought to get back to being a good prudential supervisor doing the stress tests and looking at the results, counseling banks, but not approving dividends and share buybacks and having the whole world know. That's one of the major responsibilities of directors."

Cornelius Hurley, director of the Boston University Center for Finance, Law and Policy, agreed, saying the U.S. central bank has emerged as the de facto equity research firm to the industry, except that such organizations don't set dividend policy.

"With its stress tests, the Fed has now crossed the line from being the regulator of banks to being the manager of banks," said Hurley. "In its effort to avoid more taxpayer bailouts, the Fed has taken upon itself the responsibility of deciding the banks' capital levels, dividend policies and even the business lines they will engage in."