Fed Releases Methodology of Stress Tests
Here is a summary of the details the Fed released today regarding the "stress tests" for large U.S. banks:
- Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized. However, losses associated with the deepening recession and financial market turmoil have substantially reduced the capital of some banks.
- Lower overall levels of capital—especially common equity—along with the uncertain economic environment have eroded public confidence in the amount and quality of capital held by some firms, which is impairing the ability of the banking system overall to perform its critical role of credit intermediation.
- Given the heightened uncertainty around the future course of the U.S. economy and potential losses in the banking system, supervisors believe it prudent for large bank holding companies (BHCs) to hold additional capital to provide a buffer against higher losses than generally expected, and still remain sufficiently capitalized at over the next two years and able to lend to creditworthy borrowers should such losses materialize.
- The purpose of the Supervisory Capital Assessment Program (SCAP), which is being conducted by the supervisory agencies, is to assess the size of these capital needs. The SCAP is a forward-looking exercise designed to estimate losses, revenues, and reserve needs for BHCs in 2009 and 2010 under two macroeconomic scenarios, including one that is more adverse than expected.
- Should the assessment indicate the need for a BHC to raise capital or improve the quality of its capital to better withstand losses that could occur under more stressful-than-expected conditions, supervisors will expect that firm to augment its capital to create a buffer.
- A need for additional capital or a change in composition of capital to build a buffer under an economic scenario that is more adverse than expected is not a measure of the current solvency or viability of the firm.
- To determine the necessary capital buffer, supervisors did not rely on a single indicator of capital, but examined a range of indicators of capital adequacy including but not limited to pro forma equity capital and Tier 1 capital, including the composition of capital.
This news has turned out to be pretty much a non-event so far, in terms of moving the market. The financial sector (XLF) is still higher on the day by +1.6%. If the SPX closed at current levels, it would equal a decline of -1.0% for the week. Still an hour and a half to go--