Bloomberg News

Fed Said to Criticize Banks on Risk Models in Stress Test

May 01, 2012

Federal Reserve  Chairman Ben S. Bernanke. Photographer: Jim Watson/AFP/Getty Images

Federal Reserve Chairman Ben S. Bernanke. Photographer: Jim Watson/AFP/Getty Images

The Federal Reserve criticized how some of the 19 largest U.S. banks calculated potential losses and planned dividends in this year’s stress tests, people with knowledge of the process said.

The critiques will be part of feedback letters sent to the lenders this week that cover everything from data collection to risk measurement, said three of the people, who declined to be identified because communications with the Fed are private. Flaws included marking down all housing prices at the same rate, rather than matching them to specific regions, and planning dividends (C:US) that could drain needed capital.

“A 20 percent decline in national house prices would mean that prices would decline substantially more in some markets and less in others,” Daniel Tarullo, the Fed governor in charge of supervision, told a Chicago banking conference on April 10. “The result would be higher overall losses than if prices had declined by a uniform 20 percent everywhere.”

The letters arrive as tensions mount between the largest banks and the Fed over how new rules to make the financial system safer will be carried out. Bankers have complained the stress tests completed in March lack transparency and underestimate their underwriting abilities, resulting in higher losses on some asset classes than the lenders projected.

Detailed Feedback

“We strongly urge the Federal Reserve to provide detailed explanations of methodologies, models, techniques and underlying assumptions,” five banking trade groups led by the Clearing House Association said in an April 27 letter to the Fed. “It is simply unfair to ask a bank to pass a test -- and manage toward the standards of that test -- if the parameters are largely unknown.”

The Fed critiques are the most detailed feedback the banks have received on their 2012 stress-test submissions. Among the models singled out for criticism are those that showed progressive instead of abrupt leaps in credit losses in the stress scenario as unemployment rose and the economy shrank.

The central bank developed the stress tests during the depths of the financial crisis as Chairman Ben S. Bernanke sought to gauge the strength of the banking system, and lawmakers have made them an annual requirement for the biggest lenders. Regulators have said they want banks to manage their capital to limit the risk of future taxpayer bailouts.

The Fed probably will push back when banks’ dividend payout plans exceed what’s feasible under the companies’ own projected losses as it may indicate a break in communication between risk managers and boards.

Citigroup Rejected

“Significant deficiencies in the capital-planning process” may result in a bank failing the test, Tarullo said last month.

Citigroup Inc. (C:US), the third-largest U.S. bank by assets, had its capital plan rejected in the March tests. Chief Executive Officer Vikram Pandit had told investors he was ready this year to return capital, which typically involves higher dividends or buying back shares. Pandit said April 16 the New York-based company expected more information from the Fed and must submit a revised plan by mid-June.

“The process wasn’t perfect,” said Scott Talbott, senior vice president for government affairs at the Financial Services Roundtable, whose members include Bank of America Corp. (BAC:US), BB&T Corp., and State Street Corp. (STT:US) “We will continue to work with the Fed as both the regulator and the banks find ways to strengthen the process.”

Judicious Decisions

Tarullo will meet with bankers and address their complaints tomorrow in New York, where he’s scheduled to speak at the Council on Foreign Relations. Barbara Hagenbaugh, a Fed spokeswoman, declined to comment on the meeting.

Tarullo said he views the stress test as evolving, and seeks ways to give a better sense of how the Fed’s models work, without allowing banks to copy them. The concern is that if the models become public, boards and managers will neglect to truly examine the risks they’re taking. Instead, the Fed wants financial firms to develop their own methods and make judicious decisions with capital.

That didn’t always happen. The 19 largest lenders paid out more than $43 billion in dividends in 2007 on the eve of the subprime-mortgage meltdown and an additional $39 billion in 2008, the Fed’s former top regulatory director, Patrick Parkinson, said last year.

Capital Planning

Part of the stress test now involves capital planning where bank boards are asked to determine how much cash they can afford to use for stock buybacks or pay to shareholders in dividends in the future while staying above regulatory minimum capital requirements in a severe recession.

The 2012 stress test was the third since 2009 and the most severe yet. Portfolios were subjected to a scenario that included U.S. unemployment at 13 percent, a 50 percent drop in stock prices, and a 21 percent decline in housing prices. Fifteen of 19 U.S. banks tested maintained capital ratios above four separate regulatory minimum levels even after proposed capital actions such as dividend payments.

The results exceeded Fed officials’ rough estimates of how much capital financial firms had accumulated over the past year, and in some ways proved the value of the capital-planning discipline that is now conducted annually. The Fed assigned about 200 people to the exercise and the data request from the banks was one of the largest ever. Lenders probably will have to give the Fed even more next year.

James Abbott, senior vice president in charge of investor relations at Salt Lake City-based Zions Bancorporation (ZION:US), said the tests could crimp lending.

‘Economic Weakness’

“Certain loans are inherently more susceptible to economic weakness,” Abbott said. If these loans end up reducing benefits to shareholders because of a stress test, then “we have to be very, very careful of what specific types of loans we make.”

Zions, which had $53 billion in total assets (ZION:US) at the end of the first quarter, was part of a second set of 11 banks that conducted their own stress tests and had their results reviewed by the Fed.

“Right now, we have a startup issue,” said Jeffrey Brown, a managing director at Promontory Financial Group in Washington, which consults with lenders on capital planning. The Fed is developing and applying a program at the same time, so there’s bound to be friction, he said.

The Fed “should be trying to get to the fair answer” on risk and explain why their models diverge from the banks, said Brown, a former head of risk analysis at the Office of the Comptroller of the Currency.

Effect on Markets

Separately, JPMorgan Chase & Co. (JPM:US) said a Fed proposal to cut risk by capping a bank’s dealings with any one lender, corporation or foreign government fails to strike the “correct balance” and may harm financial markets.

The plan “could destabilize markets,” Barry Zubrow, executive vice president of corporate and regulatory affairs for JPMorgan, said yesterday in a comment letter to the central bank. The Fed is reaching “well beyond” the Dodd-Frank financial-reform legislation with “disruptive” standards that duplicate or conflict with other rules and directives, he wrote.

Lenders including New York-based JPMorgan, the largest and most profitable U.S. bank, are resisting Fed efforts to impose tougher restrictions on too-big-to-fail firms whose collapse could hurt the broader economy. Concentration of risk in derivatives was blamed in part for the banking system’s near- collapse in 2008 by the Financial Crisis Inquiry Commission’s January 2011 report.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Dakin Campbell in New York at dcampbell27@bloomberg.net; Dawn Kopecki in New York at dkopecki@bloomberg.net

To contact the editors responsible for this story: Rick Green at rgreen18@bloomberg.net; Christopher Wellisz at cwellisz@bloomberg.net


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