On Friday, the Federal Reserve issued a white paper outlining the methodology behind the stress tests that examiners used to assess the ability of the 19 largest U.S. banks to cope with baseline and worse case macroeconomic scenarios for 2009 and 2010. They will make the findings of the stress tests, called the Supervisory Capital Assessment Program (SCAP), public on May 4.
The first sentence goes: Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized. Really? Maybe someone can help me here. I got the impression from an April 21 piece in the LEX column of the Financial Times of London that there was a bit of a shortfall. It says:
McKinsey estimates that US banks still hold about $2,000bn in impaired assets. By comparison, the Federal Deposit Insurance Corporation estimated that US banks had tier one capital at year-end of just $1,296bn. That $700bn gap is simply too big to be breached by earnings power.
Could one reason for the discrepancy be due to different approaches to valuing loan portfolios — with SCAP using the banks convention of carrying them at amortized cost instead of mark-to-market? As the white paper states:
Loans held in portfolio subject to accrual accounting are carried at amortized cost, net of an allowance for loan losses. The use of accrual accounting for these assets is based on BHCs’ intent and ability to hold these loans to maturity, which reflects, in part, a combination of more stable deposit funding and information advantages about the quality of the loans they underwrite. The economic value of loans in the accrual book is reduced through the loan loss reserving process when repayment becomes doubtful, but is not reduced for fluctuations in market prices .
Oh, wait a minute. Reading down further, the white paper does admit the banks do need capital after all. Its needed because the economy is going to get worse and present capital bases may not be able to cope with the expected loan losses:
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 loses materialize.
The government stands ready to help out:
The United States Treasury has committed to make capital available to eligible BHCs through the Capital Assistance Program as described in the Term Sheet released on February 25. In addition, BHCs can also apply to Treasury to exchange their existing Capital Purchase Program preferred stock to help meet their buffer requirement.
On page 4 we are given some detail on how the data for the estimates were collected:
The BHCs (bank holding companies) were asked to estimate their potential losses on loans, securities, and trading positions, as well as pre-provision net revenue (PPNR) and the resources available from the allowance for loan and lease losses (ALLL) under two alternative macroeconomic scenarios.
I must admit my initial reaction was similar to Professor Robert Salmons. In his words:
So if I understand this correctly, the Treasury is relying on banks to provide them with an assessment of their current troubles. This is like asking an alcoholic if he thinks he has a problem.
We also get detail on the parameters used in the baseline and adverse scenarios projected for 2009 and 2010. These are already well known and many observers have commented that developments in the economy now suggest the adverse scenario would have been more fitting to use as the baseline scenario.
The stock markets reaction was interesting. It seemed a little uncertain how to interpret the report. There was an initial dip on the news, followed by a rally. Then near the close, there was a rather sharp drop — but not enough to wipe out the days gain. Bad omen that last bout of selling? Last Friday, as I recall, there was a similar finish to the trading day and Monday endeddecidedly down.
To see the Federal Reserve white paper, click here.