Federal Reserve says bank tests could be better

The good news is that banks have been passing their so-called stress tests. The not-so-good news is that those tests may need some improvement. The Federal Reserve continues to push banks to make sure the tests accurately reflect the ability to withstand an economic downturn.

Here’s the story from the Wall Street Journal:

The Federal Reserve said some of the largest U.S. banks are stumbling in efforts to assess their own potential risks and financing needs, raising the possibility that banks could be pushed to increase their capital or curtail dividends and share buybacks to satisfy regulators.

Most large banks have made progress in evaluating and preparing themselves to withstand a severe economic downturn, the Fed said in a study released Monday. But it said there is “still considerable room for advancement” in the so-called stress tests run by some individual firms.

The study didn’t identify any firms by name, but it is a shot across the bow from Fed officials, who have increasingly tied strong capital plans that meet the Fed’s muster to a banks’ ability to reward investors with share buybacks and dividends.

It also is the latest indication of how, five years after the onset of the financial crisis and ensuing government bailout of Wall Street, regulators remain concerned about the behavior of some of the most complex banks and see a need to bolster balance sheets with richer forms of capital.

The Fed’s push is likely to further inflame bank executives, who have complained the Fed’s annual stress tests have become a de facto capital requirement. Industry officials have warned that the ever-higher levels of capital banks are being required to hold could curtail lending to businesses and consumers.

They also have expressed concern that the Fed’s stress tests amount to a “black box” that firms can’t recreate and give the Fed to much flexibility in evaluating their capital plans.

The New York Times pointed out that the tests have created tension since it can determine how much they’re able to pay in dividends and other methods of returning capital to shareholders:

The tests have created tension between the Fed and the banks. One reason is that the tests can determine how much a bank is allowed to pay out in dividends or spend on stock buybacks.

In March, the Fed announced that two out of 18 banks had effectively failed the latest tests. One was BB&T, a regional bank based in Winston-Salem, N.C. The other was Ally Financial, a consumer lender that has struggled to right itself since the financial crisis and still has not fully repaid its bailout money to the government. Also in March, JPMorgan Chase and Goldman Sachs passed the latest tests, but the Fed said their responses contained weaknesses, and the banks were required to resubmit their plans by the end of September.

“We continue to work with the Fed and will resubmit in September,” Goldman Sachs said in a statement.

In its review released on Monday, the Fed appeared most concerned that banks were applying the tests too generally. In other words, banks did not pay enough attention to the risks that were particular to their assets and operations. Banks excluded material that was relevant to the bank’s “idiosyncratic vulnerabilities,” the Fed said.

Under the tests, the banks have to assume weakness in the economy and turmoil in the markets, and then calculate the losses they would suffer under such conditions. The banks then subtract those losses from capital, the financial buffer they maintain to absorb losses. If the assumed losses cause capital to fall below a regulatory threshold, the banks effectively fail the test.

Bloomberg reported the details of how banks were putting together their stress tests and how they evaluate capital:

Areas where some banking companies “continue to fall short of leading practice” include not being able to show how risks were accounted for and using stress scenarios and modeling techniques that didn’t account for a bank’s particular risks. The Fed was critical of banks that generated projections for loss, revenue or expenses with approaches “that were not robust, transparent, and/or repeatable, or that did not fully capture the impact of stressed conditions.”

The Fed criticized “capital policies that did not clearly articulate” a banking company’s goals and targets and “did not provide analytical support for how these goals and targets were determined to be appropriate.” It also found examples of “less-than-robust governance or controls around the capital planning process, including around fundamental risk-identification.”

Banks this year also were required to submit their own stress test to the Fed, which supervisors reviewed to ensure the institutions understood their particular risks and vulnerabilities.

“The range of observed practice for developing” bank holding company “stress scenarios was broad,” the report said.

Banks with credible stress tests demonstrated a clear link between an adverse event and the company’s outlook. Banks with less credible tests weren’t as clear about how their regional or industry concentrations were linked to “relevant geographic or industry variables,” the report said.

The original round of tests in 2009 went a long way to stabilize the market and offer some confidence in the banks after the financial crisis. Now, the tests continue to point out shortcomings at several of the banks, which likely isn’t helping sentiment. The big question is whether investors are paying attention to these or if they’re blowing them off since the economy is looking better.