Executive Summary

After baited-breath market anticipation, the Federal Reserve released the “supervisory capital assessment program” (SCAP) – aka, the stress test – on which the strength of the nineteen largest banks is being judged.  In hopes of limiting market volatility, the release makes clear that the SCAP is a “what-if” exercise and that even banks that fall short under it may well be both viable and solvent.  The release also defends the SCAP against criticism that it is too lenient or otherwise flawed, again in hopes of quelling market problems and stabilizing the banking sector.  The FRB emphasizes that banks that need capital can get it from Treasury either through the new capital assistance program or by converting prior preferred stock into common equity.  Importantly, the test does not rely on a single capital measure – regulatory versus tangible common equity – although the statement reiterates longstanding regulatory policy that common equity should be the predominant form of regulatory capital.  The document stresses that it in no way establishes a new capital standard, although it does incorporate pending improvements to the current rules to ensure a tough capital assessment.  This report analyzes the stress test methodology which now will lead to announcements on May 4 about how well banks have done after those that can so revise their positions in the interim to improve their results.

Analysis

The FRB document includes a discussion of why the SCAP differs from conventional stress tests, refuting criticism that this is something banks and regulators already should have done.  It notes the complexity of creating a common regulatory process for complex institutions and for trading and other business lines not often incorporated for a firm-wide, not business-line, stress measurement.  The SCAP is based on accrual – that is, hold-to-maturity – accounting.  However, the trading-book reviews (required for the five banks with large trading positions) do reflect market valuation, as well as anticipated counterparty credit risk.    

Although banks were given supervisory loss rates for individual asset classes, they were, with permission, permitted to diverge from these.  This may reflect institution- specific factors (e.g., concentrations in high- or low-risk books), but it is likely that this  variability will be among the most hotly-contested matters as banks review SCAP results in the next few days.  Importantly, the tests are dynamic – for example, banks were required to anticipate credit line drawdowns and securitization-recourse arrangements.  Conversely, banks were allowed to factor in dynamic factors on the positive side – e.g., revenue.     

In its defense, the FRB also notes that the adverse scenario in the test – often criticized as too weak – is not meant to be a worst-case scenario, but rather a reasonable estimate of potential stress beyond the consensus estimate on which the baseline test is based.  It defends the house-price assessment – key to the test – as still reflective of market conditions despite worsening conditions since the tests were announced in February.

The SCAP document also includes a detailed discussion of how loss assumptions were derived for each key component of the test, detailing how the basic loss estimates were then adjusted for each BHC.  The document also discusses how the held-to-maturity securities portfolio was judged, with the FRB noting that regulators paid particular, critical attention to banks with large concentrations of accumulated other comprehensive income (AOCI) relative to tangible common equity (TCE).  New FASB mark-to-market guidance was considered when banks included it in their resubmissions, but this was not done in the more-adverse scenario to ensure its stringency.  For the trading book, the regulators first looked at the five big banks’  projections and then stressed them as deemed appropriate.  The SCAP included an incremental default charge even though this is a work in progress in the regulatory- capital requirements, noting that firm submissions here varied widely and were normalized by the supervisors.     

One of the most interesting aspects of the test addressed a pending FASB consolidation requirement.  The supervisors concluded that the changes to FAS 40 could bring as much as $900 billion of assets back to bank balance sheets.  These were risk adjusted to add $700 billion in assets and the results then factored into measuring capital adequacy.  Merger-related loan discounts (estimated at $90 billion) were also assessed to determine if they are adequate to in fact reflect real anticipated losses.    

Final capital assessments will revise the stress-test ones to assess year-to-date activity and corporate activities (e.g., divestiture, capital raising, etc.)  Although not detailed in the SCAP, this revision is now under way as banks review the results and take whatever steps possible to improve the result set for release on May 4..