US stress tests set to force banks to hold equity

US stress tests set to force banks to hold equity
By Krishna Guha
Copyright The Financial Times Limited 2009
Published: April 23 2009 23:33 | Last updated: April 23 2009 23:33
http://www.ft.com/cms/s/0/d83753b0-304f-11de-88e3-00144feabdc0.html


US banks could be forced to hold more equity than initially expected after it emerged that “stress tests” organised by regulators take into account risks not commonly understood to be included in the assessment.

In addition to looking at potential losses on loans and securities, bank examiners are looking at so-called “counter-party risk” on derivatives contracts – the chance that the party on the other end of a derivatives deal might default, depriving the bank of a payment that is due.

They want to be sure that each bank has enough capital to cover this potential source of loss as well as its more traditional lending risks.

In the past regulators have focused on traditional lending risks that form the basis of bank capital requirements. The stress test provides a more rounded assessment of the amount of equity a bank needs in order to be considered well capitalised, relative to the risks it is running.

This means banks that have incurred large counter-party risks in their trading books could be forced to hold more capital.

The stress tests were designed to ensure that the top 19 US banks have enough capital in general, and equity in particular, to comfortably survive a deeper than expected recession.

They were also intended to provide more standardised information about bank asset portfolios, which policymakers hope will enable them to raise equity from private investors.

Investors are on tenterhooks before the release of results, which will be discussed with bank executives from Friday ahead of their scheduled publication on May 4.

Meanwhile, bank regulators will on Friday explain the methodology used to assess the banks in a white paper intended to end uncertainty about the nature of the tests while reassuring sceptics that the process was rigorous.

The white paper will explain the treatment of different types of asset such as first and second lien mortgages, commercial real estate, credit cards and securities. In each case bank examiners have looked at likely losses over the next two years.

Supervisors have also asked banks to estimate what an adequate amount of loan loss reserves might be at the end of the two-year period – thus taking into account expected losses across a much longer lifetime of the loans.

The white paper will also set out the approach taken to evaluating banks’ operating earnings – which can help to offset losses on loans and securities.

Policymakers have debated whether they should interpret the stress test outcomes in a more stringent light given fast-rising unemployment. Loss estimates on loans are already quite tough.

The authorities are paying close attention to tangible common equity ratios. However, they will not simply impose a single TCE ratio on all banks but will vary their demands based on the quality of a bank’s assets and the risks it is running.

Analysts have wildly different expectations as to the total amount of capital that the stress tests will identify as needed. Keefe, Bruyette and Woods, a brokerage firm, said on Thursday that its version suggests “$1,000bn (€765bn, £683bn) of capital would be needed industrywide”. Others think much less capital will be required.