Banks’ Stress Tests: Too Cloudy for Treasurers?

The proposed annual stress tests of the largest U.S. banks may not be very useful for CFOs trying to assess the health of financial institutions.
Vincent RyanJanuary 20, 2012

The Federal Reserve and the Federal Deposit Insurance Corp. are moving forward on requiring annual stress tests of the largest U.S. banks. This week, the FDIC released its proposal to annually stress-test 23 banks with assets over $10 billion. The Federal Reserve issued a similar notice of proposed rulemaking last December.

The aim of the tests is to ensure banks have sufficient capital to withstand large losses in adverse economic conditions and that they construct capital-planning processes that are risk-averse. Among other things, the results will help regulators decide if individual banks are strong enough to issue dividends or repurchase stock.

Outside of the biggest banks and regulators, though, it’s unclear whether the stress tests will be of any informational value to anyone else — corporate bank customers and their treasury departments included. That’s because the data released publicly may not be institution-specific or detailed enough to be meaningful in a risk assessment, says Mark Zandi, chief economist for Moody’s Analytics.

Dodd-Frank mandates only that banks “publish a summary of stress-test results.” The FDIC proposal says banks will file a report by January 5 every year and then publish a summary within 90 days. There are no details, however, on what should be in the summary.

On an annual basis, “it’s not clear how much detail will be provided on individual banks’ performance,” says Zandi. “If they don’t have a certain level of transparency it may make [people] more confident in the entire banking system, but not in any individual bank.”

For this year’s tests, called the Comprehensive Capital Analysis and Review, the Federal Reserve says it will provide bank holding company–specific data on measures such as projected loss rates for major loan categories, losses on securities held in available-for-sale and held-to-maturity portfolios, and losses from trading portfolios and counterparty credit-risk positions. But these parameters may not make it into the final rule. In addition, the publication of test results won’t happen until months after the banks submit their reports to the Fed.

This year, the 19 largest bank holding companies had a deadline of January 9 to submit capital plans. The Fed will give a thumbs up or thumbs down to capital distributions by March 15 and then provide the banks more feedback on their capital adequacy by April 30. Only at the end of the process (the Federal Reserve doesn’t give a date) will regulators release the results of the “supervisory stress scenario” to the public. That stress test includes the most severe set of economic crisis conditions that banking regulators cooked up.

The scenario runs from the fourth quarter of last year through the end of 2014. It includes more than 25 variables, including five measures of economic activity and prices, four measures of asset prices, and four measures of interest rates. How bad a scenario has the Fed created? In the second quarter of 2013, the unemployment rate jumps to 13.1%; in the third quarter of 2012, real GDP growth contracts 3.52%; and in the first quarter of 2013, the Dow Jones Industrial Average falls to 6,082.47.

“They’re trying to construct an economic scenario that is on the tail of the distribution of possible economic outcomes,” says Zandi.

Still, banking regulators have some learning to do about constructing usable scenarios, he says. Despite all the tables of numbers the Fed is providing banks, when the stress tests become a permanent fixture the Fed may need more explicit narrative about an economic meltdown, says Zandi. “[Are the numbers] due to a housing crash, skyrocketing interest rates, or an unraveling of the eurozone? For banks this has a big impact on what is affected and by how much,” he says.

The biggest utility of the stress tests may wind up being the workouts they give the stress-testing groups inside banks. “The time lines involved are short” says Zandi. “It’s not just stressing the balance sheet but the stress-testing process within the bank — to ensure it is well functioning and efficient and the bank can run [a test] quickly if there is a crisis.”