November 22, 2011 9:02 pm

Fed sets US banks toughest ‘stress tests’

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The Federal Reserve will force the biggest US banks to “stress test” their balance sheets against a severe eurozone recession and a US unemployment rate of 13 per cent as part of a wide-ranging exercise launched on Tuesday.

The second annual “comprehensive capital analysis and review” is designed to ensure that US banks are adequately capitalised to weather an economic storm at home and abroad, including a peak decline of 6.9 per cent in eurozone real gross domestic product. The Fed emphasised the scenarios were “not forecasts”.

The 19 biggest banks face public disclosure of their estimated capital levels and revenues under the stress scenario, while the six biggest trading institutions – including Bank of America and Goldman Sachs – have to factor in an additional “global market shock” stemming from a worsening eurozone crisis.

“My baseline for all this is towards more disclosure and standardised and regularised disclosure,” said Daniel Tarullo, the Fed governor in charge of financial regulation. Last year’s results had less bank-specific information and the pledge of more published data has the potential to reassure or frighten investors.

Banks that do poorly on the exercise – which also judges their capital planning and risk management – will be prevented from paying out increased dividends or share buy-backs. BofA’s capital plan was rejected this year. The Fed said that even healthy banks which propose dividends of more than 30 per cent of net income would “receive particularly close scrutiny”.

They have to show that their core “tier one common” equity remains above 5 per cent even under the stress scenario. The Fed has not ruled out forcing banks to raise capital if they fall short in the tests, which have to be completed by January. Results will be published in March.

Some banks have complained that the testing is too onerous as they cancel vacation for employees working on the modelling and prepare to wade through individual loan files to find the data required by the Fed.

In 2009, the Fed’s first stress tests proved a landmark moment in restoring faith in the banking system after the crisis when officials published results of their work that reassured investors. European tests have failed to achieve the same results, with concern that they were not sufficiently rigorous.

Worries over Europe’s worsening economy and fragile banking system have plagued US bank stocks this year, with shares in BofA and Morgan Stanley down by more than 60 and 50 per cent, respectively, and Citigroup and Goldman down by more than 40 per cent.

More than 30 banks have to participate in the tests compared with 19 in previous years, including any bank with more than $50bn in assets. The smallest of the group have to provide less information to the Fed.

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