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Fed releases 'stress-test' criteria

Bank stocks rose Friday, but some question whether the evaluation of the nation’s major banks is tough enough.

By Staff writer / April 24, 2009

Testing: The Federal Reserve met privately with bankers Friday on the "stress-tests" of the nation's big banks. Left, officers guard the Federal Reserve building in New York.

Louis Lanzano/AP

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Regulators delivered a simple but important message Friday: Some of the biggest US banks don't have enough of a capital cushion to fulfill their “critical role” in the economy.

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The Federal Reserve laid out that general point in a public report, and in private the Fed began acting on its assessment. It called top bankers into meetings Friday to tell them whether their particular institutions need a balance-sheet boost.

Some big banks are being asked to raise more capital. This would serve two key purposes in the current recession: It acts as a cushion against losses and it provides seed money for new loans.

If the banks that need capital can’t raise it in the form of private equity, the investor will be the US Treasury.

In its public report, the Fed described the methods bank supervisors used in so-called “stress tests” to assess the health of the major banks.

The assessment is part of the Obama administration’s efforts to pull the economy out of recession. The Treasury’s Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corp., worked alongside the Fed in conducting the tests.

“Given the heightened uncertainty around the future course of the US economy and potential losses in the banking system, supervisors believe it prudent for large bank holding companies to hold additional capital to provide a buffer,” the Fed’s report said.

Though the actual results of the tests won’t be released until May 4, bank stocks rose Friday.

The assessment, as outlined in the report, involved:

- Looking deep into banks’ books, evaluating both likely losses and the likely income that banks will have to offset those losses over the next two years.

- Considering outcomes in both a baseline economic scenario and a worse-than-expected case. The pessimistic case called for gross domestic product (GDP) to decline by 3.3 percent this year and to grow by 0.5 percent next year. It called for the unemployment rate to reach 10.3 percent, and for home prices to fall by another 29 percent, by 2010.

- Calling for enough capital so that banks can keep lending and cover the losses likely to materialize through 2011 in a worse-than-expected scenario.

- Emphasizing common stock as the most important form of capital. Bank capital can also come in other forms, but in times of stress a supply of common equity provides the safest cushion against losses.

- Evaluating a diverse set of banks using common benchmarks. Although banks may have their own individual models of forecasting loan performance, examiners tried to “apply a consistent and systematic approach across the group.”