Thursday, May 06, 2010

Bernanke on Stress Tests

by Bill McBride on 5/06/2010 09:58:00 AM

From Fed Chairman Ben Bernanke: The Supervisory Capital Assessment Program--One Year Later

Importantly, the concerns about banking institutions arose not only because market participants expected steep losses on banking assets, but also because the range of uncertainty surrounding estimated loss rates, and thus future earnings, was exceptionally wide. The stress assessment was designed both to ensure that banks would have enough capital in the face of potentially large losses and to reduce the uncertainty about potential losses and earnings prospects. To achieve these objectives, for each banking organization included in the SCAP, supervisors estimated potential losses for each major category of assets, as well as revenue expectations, under a worse-than-expected macroeconomic scenario for 2009 and 2010. Importantly, the SCAP was not a solvency test; rather, the exercise was intended to determine whether the tested firms would have sufficient capital remaining to continue lending if their losses were larger than expected. The assessment included all domestic bank holding companies with at least $100 billion in assets at the end of 2008--19 firms collectively representing about two-thirds of U.S. banking assets.
The assessment found that if the economy were to track the specified "more adverse" scenario, losses at the 19 firms during 2009 and 2010 could total about $600 billion. After taking account of potential resources to absorb those losses and capital that had already been raised or was contractually committed, and after establishing the size of capital buffers for the end of the two-year horizon that we believed would support stability and continued lending, we determined that 10 of the 19 institutions would collectively need to raise an additional $75 billion in common equity. Firms were asked to raise the capital within six months, by November 2009. Importantly, we publicly released our comprehensive assessments of each of the firms' estimated losses and capital needs under the more-adverse scenario. Our objective in releasing the information was to encourage private investment in these institutions, and thus bolster their lending capacity. If private sources of capital turned out not to be forthcoming, however, U.S. government capital would be available.
The good news is the economy has performed better than the "more adverse" scenario, especially house prices and GDP - although unemployment is still much worse than the "baseline" projections.

The bad news is one of the key goals has not been met: to "bolster lending". From Bernanke:
Our goal ... was to accomplish more than stability; for example, in the SCAP, by setting reasonably ambitious capital targets, we hoped also to hasten the return to a better lending environment.

Clearly that objective has not yet been realized, as bank lending continues to contract and terms and conditions remain tight.
Several analysts (like Meredith Whitney yesterday) are questioning the health of the banks. Perhaps it is time to repeat the stress tests (make them an annual exercise like the FSA in the UK), publish the scenarios for five years (baseline and more adverse), and also make the results public.