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 Banks are struggling to figure out what exactly the U.S. Federal
Reserve is looking for when it conducts its annual "stress tests,"
which measure how banks will hold up during times of economic
turmoil, bank executives, former Fed officials and consultants
involved in the process told Reuters.
In gatherings organized by industry groups as well as more informal
forums, executives say they have swapped tips about everything from
how to best communicate their data – regulators evidently appreciate
robust summaries -- to how to project legal losses in a hypothetical
downturn.
The Federal Reserve deliberately keeps quiet about how it measures
lenders' performance during downturns, to prevent banks from finding
loopholes in the process that would allow them to take more risk,
senior regulators have said publicly. It has given banks a little
more information recently, but many executives still gripe about the
tests.
"You put something in and one year it's okay and the next year they
say 'no,' and you're scratching your head," said one bank executive.
The executive, like others that spoke to Reuters, spoke about the
stress tests on the condition of anonymity.
A few years ago, banks might have hesitated to share information
with rivals about how they measure risk and how they communicate
with the Federal Reserve. Their willingness to talk to competitors
about these issues underscores just how exasperated they are with
the process.
The Fed does not mind the information sharing, because the banks do
not share confidential supervisory information and it is not
collusion in any legal sense - it does not result in price fixing or
evidently hurt customers in any other way, the executive said. A Fed
spokesman declined to comment.
Regulators have multiple tools for keeping banks in check, including
global capital rules known as "Basel III," which rule-makers
world-wide have been crafting for years. But Basel III is viewed by
the Fed as flawed, because it gives so much leeway to banks to
measure how risky certain assets are.
The Federal Reserve has more control over the stress test process,
which is part of its annual Comprehensive Capital Analysis and
Review. Many analysts believe the Fed will not hesitate to use
stress tests to pressure banks to make their balance sheets safer.
"The Fed will likely use the CCAR process as a way to help drive
capital requirements even higher for the largest U.S. banks," said
Steven Chubak, a bank analyst at Nomura.
As part of the CCAR process, the Fed lists a series of bad scenarios
for the financial sector - for example, U.S. economic activity
shrinking by 4.25 percent over nine future quarters and unemployment
spiking to 11.25 percent, and banks estimate how much their assets
will deteriorate in those scenarios.
They submit reports that run into the thousands of pages to
regulators who then make their own estimates for how banks would
perform using Federal Reserve models. If the Fed does not like what
it sees, the bank cannot increase dividends to shareholders or buy
back more stock.
A WIDE GAP
What irks banks is that their stress test results and the Fed's are
often far apart, and regulators give little information about how or
why they disagree.
For instance, in 2014 Zions Bancorporation, <ZION.O> a Salt Lake
City, Utah-based bank with $55 billion of assets, said its
assessment showed it passed the stress tests: in a hypothetical
downturn, it would have capital equal to about 5.9 percent of its
assets, above the Fed's 5.0 percent threshold. But the Fed ruled
Zions's capital ratio would fall to 3.6 percent in its scenario and
issued a failing grade.
Executives also complain that strong capital levels are often not
enough: well-capitalized banks can still be prohibited from paying
out more dividends for "qualitative" reasons, such as a flaw in its
capital planning process. Banks including Citigroup Inc, BB&T
Corp and Ally Financial Inc have failed the qualitative portion of
the stress tests in recent years.
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To combat the opacity, banks have met in forums hosted by the
Clearing House, a trade group for big U.S. commercial and retail
banks, the American Bankers' Association, and at other informal
venues.
Among the problems they have discussed is how to effectively write
their reports, which must contain detailed information on the
mathematical models they employ as well as a narrative piece that
describes a lot of the methods that banks used to arrive at their
conclusions. Executives say it is a challenge to produce a document
that clearly and concisely explains everything to Fed modelers and
examiners who may be unfamiliar with individual institutions.
One senior executive at a large U.S. bank involved in the
stress-test process said one thing the Fed pays close attention to
is the changes a bank made since the last submission. Instead of
describing those changes in an appendix, the executive has learned
the Fed preferred it to be addressed at the beginning of the
document.
The executive added that given that the Fed has a limited period of
time to review submissions, examiners have told other banks that
they prefer to see a more detailed executive summary.
The Fed itself has taken some steps to help banks get a better sense
of its expectations on the qualitative portion of the stress tests
and how banks should organize their information - its October
instructions for the 2015 stress test included a section on their
preferential format.
The instructions also contained a "common themes" appendix that
explained issues the Fed was looking closely at, such as if
assumptions banks used to estimate losses are clearly articulated
and how banks account for potential limitations and weaknesses in
the models they use.
But some executives say that the more specific information about
what it is looking for is not helpful if the Fed does not detail how
it reached its conclusions.
"We've had a lot of conversations about methodologies and the
approach to transparency in the CCAR process that have been more of
a concern," said Chris Halmy, finance chief of Ally Financial Inc,
in an October interview. Ally has been seeking clarity "less about
instructions and more about the feedback," Halmy said.
Another unresolved issue that banks have been powwowing about is how
to estimate legal losses nine quarters into the future. In its
common themes appendix, the Fed faulted many banks' projections and
said they needed to take into account "possible claims of all
types."
Legal losses are notoriously difficult to forecast. Without any more
specifics about what the Fed wants banks to incorporate into their
forecasts, it is a struggle to produce a result that will satisfy
regulators, said one consultant that does stress-testing work for
large banks.
"No one really knows what the Fed is looking for" with respect to
potential legal losses, the consultant said. "There may be some
objections to capital plans next year as a result."
(Reporting by Peter Rudegeair, editing by Dan Wilchins and John
Pickering)
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