By James Sterngold
The so-called annual stress tests for banks is becoming a
misnomer.
Conceived in 2009 by the Federal Reserve as narrow, once-a-year
snapshots of bank health, the tests have morphed into protracted
top-to-bottom examinations that have required firms to revamp their
balance sheets, hire thousands of staff and spend hundreds of
millions of dollars on preparations.
In the latest reflection of this shift, Fed officials tell The
Wall Street Journal the process is being integrated into their
year-round supervision of banks, rather than being squeezed into a
monthslong sprint each year.
This year's test results will be announced for the country's 31
largest banks Wednesday, including seven foreign-owned firms.
Most are expected to pass, but analysts and executives agree
that whatever the outcome, the Fed exams have become the primary
cudgel by which regulators are reshaping the banking industry to
guard against future meltdowns.
"It's changing the way people think about supervision," Fed
governor Daniel Tarullo, who oversees the process and helped
develop it, said in an interview. "I'm not sure we could have
foreseen how important a supervisory tool it would become."
Some bankers grouse about the process, and many executives and
industry analysts complain it is a "black box" that can be
unpredictable and make it difficult for firms to effectively plan.
That is by design, some observers say.
"The Fed likes the fact that the banks don't know exactly where
the strike zone is," said Darrell Duffie, a Stanford Business
School professor who sits on an advisory board to the New York
Fed.
Mr. Tarullo has said the Fed doesn't disclose to banks the
details of its testing models because "we certainly do not want
them to construct their portfolios in an effort to game the model,"
as he put it in a speech last year.
Banks also are concerned about the test's growing focus on
qualitative issues, such as how they identify and mitigate risks.
The Fed says those evaluations are essential for changing the
culture on Wall Street to be more wary of big risks, but banks
complain those factors can be too subjective.
The Fed's tests are formally called the Comprehensive Capital
Analysis and Review, or CCAR. The Dodd-Frank Act also requires the
Fed to conduct a separate annual stress test--those results were
released last week and all banks passed--but that exam doesn't give
the Fed the powerful authority that gives CCAR teeth: control over
the banks' capital payouts.
The regulators' control over share buybacks and dividends is
especially significant in the current low-interest-rate
environment; big payouts appeal to yield-hungry investors and the
buybacks can help improve some profitability measures.
Eugene Ludwig, chief executive officer of advisory firm
Promontory Financial Group and a former Comptroller of the
Currency, called CCAR "transformational" in part because it forces
banks to take steps such as selling riskier assets, adding capital
and rewiring their internal procedures for assessing the potential
for steep losses.
"It's quite intrusive in terms of how that supervisory process
is applied," Mr. Ludwig said.
Because of the consequences, banks are increasingly devoting
additional resources and attention to the process. After Citigroup
Inc. was stunned last year by its failure of CCAR--its second in
three years--its chief executive, Michael Corbat, said he should be
held personally responsible.
"I'll devote whatever resources and make whatever changes are
necessary to accomplish this critical goal," Mr. Corbat told
analysts last April.
Citigroup later disclosed that, while it had drastically cut
staff over the past two years in some departments, it also added
10,000 employees to ensure compliance with regulations and prepare
for CCAR.
At J.P. Morgan Chase, the nation's largest bank by assets, about
500 people have been specifically devoted to stress tests,
including developing and reviewing more than 100 new models and
conducting more than 130 independent qualitative and quantitative
assessments, the bank said in a recent report.
Banks generally don't break out their CCAR costs, but Bank of
America's chief financial officer, Bruce Thompson, and Kelly King,
the chairman and chief executive of BB&T Corp., have both
separately described the expense as "enormous." Citigroup disclosed
that it had spent $180 million just in the second half of last year
preparing for CCAR.
CCAR has also been transformative for the Fed. In the initial
stress testing in 2009, about 150 Fed staff were involved; that
number has grown to more than 600, encompassing all the regional
Fed banks, Fed officials said.
As part of the tests, Fed computer models are used to determine
how much each bank would lose under hypothetical recession
scenarios, and the Fed then evaluates whether the banks would have
enough capital to absorb those losses and still conduct
business.
"It allows us to vary the scenarios from year to year taking
into account the kinds of risks that may have arisen," Mr. Tarullo
said.
One year the scenario included a possible downturn in Europe.
This year banks were instructed to focus on the losses they would
suffer from their holdings of high-yielding leveraged loans, which
the Fed feels are particularly risky.
When banks fail the tests, they have responded: Zions Bancorp
sharply reduced holdings of collateralized debt obligations and
construction loans and raised fresh capital after failing last
year's test.
Banks even can be affected when they pass: Last year, Goldman
Sachs Group Inc. and Bank of America succeeded after they were
allowed to request lower capital payout amounts when the Fed found
shortcomings in their capital under the stressed scenarios.
Goldman later said it had conducted a comprehensive analysis of
its balance sheet and sold off $56 billion in assets. And Bank of
America raised $4.5 billion of new capital last year from issuing
preferred shares to strengthen its balance sheet.
Emily Glazer contributed to this article.
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