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The Fed Releases its Stress Test Scenario

In its first step toward disclosing the health of the country's 19 largest financial institutions, the Federal Reserve Board on Apr. 24 released the methodology behind a wide-ranging "stress test" aimed at determining which of the bank holding companies have enough capital to withstand a further deterioration of the U.S. economy.

The results for individual banks are not scheduled to be issued to the public until May 4, but the disclosure of the complete methodology for the Supervisory Capital Assessment Program will provide clues for market watchers to anticipate which banks will have enough capital to pass the test—and which will require more. Banks that underwent the stress tests were being given the results in private briefings Friday.

Two Economic Scenarios

The federal examiners—eventually comprising a team of more than 150 from the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp.—have been working since late February on the analysis of bank holding companies with more than $100 billion in assets at the end of 2008. The banks collectively hold two-thirds of the assets, or more than half the loans, in the U.S. banking system, according to the Federal Reserve.

The analysis looked at the banks' ability to withstand two economic scenarios: one mirroring the consensus of economic experts on the course of the downturn through 2010 and the second modeling a worse-than-expected course of economic activity. The Federal Reserve, in its Apr. 24 white paper on the methodology behind the stress test>, noted that "the assessment is a 'what if' exercise intended to help supervisors gauge the extent of additional capital needs across a wide range of potential economic outcomes." The central bank noted that the need for more capital "is not a measure of the current solvency or viability of the firm."

The stock market found little to worry about in the details released Friday. The Dow Jones Industrial Average rose 119.23, or 1.5%, to 8,076.29, after rising by as many as 170 points following better-than-expected quarterly results from Ford (F) and other positive economic news. Financial stocks mostly gained.

Among the factors considered in the stress test scenarios were gross domestic product, the unemployment rate, and the direction of housing prices. The stress tests measure how the banks will perform if unemployment rises to between 8.8% and 10.3% in 2010; the economy grows by 2.1% and 0.5%; and home prices drop by 4% to 7%. To determine a bank's capital needs, regulators looked at a host of different measures, including Tier 1 capital.

"Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized," the Federal Reserve said. "However, losses associated with the deepening recession and financial market turmoil have substantially reduced the capital of some banks…supervisors believe it prudent for large bank holding companies to hold additional capital."

How much additional capital might they need? A recent report from the International Monetary Fund estimates the U.S. banks will need another $275 billion to $500 billion. Analyst Frederick Cannon of investment bank Keefe, Bruyette, & Woods figures the industry may need as much as $1 trillion.

The extra capital is expected to come from the approximately $110 billion left in the Troubled Asset Relief Program (TARP), augmented by about $35 billion expected to be repaid to the government by banks, by conversion of preferred stock to common equity, and by a return of private capital to the financial sector.

"Markets would have to judge whether the gap could be bridged by private capital or some accounting shifts within TARP," analyst Tom Gallagher of International Strategy & Investments said in a recent report.

"Water Torture" for Financial Markets

John Douglas, former general counsel of the FDIC and current chair of the banking and financial institutions group at international law firm Paul Hastings, said in an interview that he thinks the stress testing is sending the wrong message to the markets and will unduly influence consumer behavior. He described the release of the methodology more than a week before the actual results as "water torture for the financial markets."

"[The 19 banks] have substantial earnings capacity to sufficiently withstand any reasonable short-term scenario," says Douglas. "The government has such a credibility problem that when they say everything is A-O.K., the market is going to go nuts because they won't believe them."

The Financial Services Roundtable, the organization representing the nation's largest financial institutions, said in a statement released Apr. 24 that it expects the results of the stress tests "to show that the overwhelming majority of financial institutions have the capital they need to help lead the country to recovery."

Carter is a department editor in the finance section for BusinessWeek in New York. Der Hovanesian is Banking editor for BusinessWeek in New York. Steverman is a reporter for BusinessWeek's Investing channel.

Carter is a department editor in the finance section for BusinessWeek in New York.
Steverman is a reporter for Bloomberg News in New York.
Der Hovanesian is Banking editor for BusinessWeek in New York.

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