Fed Plans New Stress Tests for Biggest Banks

Now in their second year, the reviews have quickly become an important tool to help regulators assess the condition of the banks and restore confidence in the financial system. They also have divided the industry between the strongest banks, like JPMorgan Chase and Goldman Sachs, which were permitted to start increasing their dividends and repurchase billions of dollars’ worth of shares this spring, and weaker institutions, like Bank of America, whose requests were denied.

The latest round of tests will give those banks another chance to convince regulators that they have regained their footing and can weather a range of unexpected financial shocks. Banks will have to complete the exams and make any requests to return capital to shareholders by Jan. 9. The Fed is expected to announce its decisions on those plans by early March.

This time, a few new twists are planned.

Unlike the previous exams, which focused on financial conditions in the United States, the new tests will require several of the big Wall Street banks to assess the potential effect of a sudden downturn on European bank loans and sovereign debt. And in an attempt to provide investors with more information, the Fed will publish its revenue and loss estimates for each of the large banks it reviews.

The Fed will also expand the scope of the exams to 31 large banks, up from the 19 biggest.

Despite the fragile economy, federal regulators have been relatively sanguine about the recovery of the nation’s banks, emphasizing that they have far more capital and cash on hand than they did in the months before the financial crisis in 2008.

On Tuesday, the Federal Deposit Insurance Corporation provided fresh evidence that the banking industry was working slowly through its problems when it released its report on third-quarter results. Profits for the nation’s 7,436 lenders rose nearly 50 percent, to $35.3 billion, compared with the period a year ago, while the number of banks at risk of failure shrank for the second consecutive quarter. In the third quarter, regulators closed 25 banks and added only a few new ones to the at-risk list. The list of so-called problem banks stands at 844, down from 865 at the end of June.

With fewer attractive places to lend or invest, banks have been stockpiling billions of dollars of excess profits. In fact, retained earnings in the third quarter reached their highest level since the height of the boom in 2006. That may give banks a freer hand to return capital to shareholders than they had in 2010, when regulators took a relatively tough stance.

Under the guidelines released Tuesday, the Federal Reserve will again evaluate the ability of the 19 largest banks to withstand losses under a set of adverse economic conditions over the next two years. Among the hypothetical situations are ones in which unemployment rises at the average rate of the last several recessions, domestic and global economic output contracts significantly, and stock and bond prices plunge starting in the fourth quarter of 2011. Six of the 19 banks with large trading operations will be required to estimate potential losses from their exposure to European debt.

Fed officials, in turn, will assess the banks’ internal capital management and any plans to increase stock dividends or buy back additional shares. The banks must show that they are strong enough to meet the new capital requirements from international accords and cope with worse-than-expected legal settlements tied to the mortgage and foreclosure mess.

The official stress tests will evaluate the condition of the 19 biggest banks, which have assets of at least $100 billion. Those include Wall Street giants like Citigroup and Morgan Stanley as well as large regional banks like PNC Financial and U.S. Bancorp. Banks owned by MetLife, the insurer, and Ally Financial, the consumer lender once known as GMAC, are also subject to the reviews.

But this year, the Fed has also ordered the next dozen largest lenders with assets of at least $50 billion to undergo what is essentially a do-it-yourself version of the exam. These institutions — including Discover Financial, Northern Trust, and Zions Bancshares as well as the United States subsidiaries of several foreign banks, like BBVA, HSBC, and the Royal Bank of Scotland — had not previously participated in formal stress tests.

They must make similar loss assumptions that will be validated by Fed officials. But the bar for the level of detail and analysis supplied by each of those banks is generally expected to be lower, given the size and scope of their activities. These stress tests, with those required for the 19 biggest banks, will help the Fed satisfy a new requirement for annual reviews of large financial companies under the Dodd-Frank financial overhaul bill.

Article source: http://feeds.nytimes.com/click.phdo?i=11fe584f187ca0d6331d6fbaf9069fa5