Fed's Tarullo Moves to Calm Bank Fears on Stress Tests

WASHINGTON — A top Federal Reserve Board official on Tuesday sought to allay concerns by the largest banks over the central bank's recent stress testing exercise, signaling a willingness to make improvements before the next round.

Fed Gov. Daniel Tarullo said that while it was clear from the tests that all banks required additional work on their annual capital planning processes, there was also ample room for the Fed to augment its own procedures.

"Just as capital planning and internal stress testing capacities could be improved at every firm, so we intend to consider both substantive and procedural improvements in our use of these tools," Tarullo said in prepared remarks at a conference hosted by the Federal Reserve Bank of Chicago.

While only five of the 19 banks failed the exercise by missing a key target, the results of the Fed's stress tests have led to a number of questions about how the central bank arrived at its numbers and why certain institutions may have missed the mark.

The Fed will begin consulting with academics, other analysts and the individual banks to help improve this relatively new supervisory process, he said.

Supervisors will also be focusing their efforts on making potential changes to the Fed's models by using more granular data, as well as forming an advisory group to advise the agency's internal model-validation team on a routine basis. The Fed is planning to hold a symposium later this year to hear from a myriad of voices.

The Fed is responding in part to criticism because a number of loss projections by the central bank often exceeded a bank's own estimates during the exercise. Banks have been left wondering why there was such a large discrepancy.

"We may gain greater insight into the source of these differences as we proceed with the review of our modeling," said Tarullo.

Tarullo offered several reasons why that may be the case, including noting that the agency's modeling tends to be much more conservative. He also said the Fed typically avoids the assumption that loss during a period of high stress can be extrapolated from what experience is like during normal times.

Already, the Fed is moving to make certain procedural changes, including when the results of the stress test will be applied.

Regulators will still notify firms whether they have approved or denied a bank's capital distribution plan based on stress test results by the end of the first quarter, but that decision will not be applied until the second quarter.

But not all issues will have quick fixes.

Regulators will be spending more time thinking about what the communication should be like between supervisors and firms during the stress test and capital planning process, addressing a large concern by institutions who felt left in the dark.

A much more delicate issue, which will require "extensive thought," is how much detailed information supervisors should be communicating about their modeling assumptions to avoid complaints by firms of a "black box" feel, Tarullo said.

"We do not want to encourage a world in which everyone simply applies the same risk-management model, rather than engages in the important and multidimensional process of evaluating and modeling risk," said Tarullo. "But there should be ways to provide some further explanation of our modeling approach without leading to this outcome, particularly in the aftermath — rather than in the middle — of the supervisory exercise itself."

Tarullo stressed any good modeling should be adaptable to take advantage of better data and improvements in risk management.

"It would not be desirable to fix upon a model and continue to use it even as it becomes stable, and thus, potentially misleading," said Tarullo.

Separately, Tarullo said stress testing requirements for institutions with $10 billion or more in assets but under the $50 billion large bank threshold would be "quite different" and that firms with $10 billion or less in assets should not expect any supervisory stress testing requirements.