Regulatory Stress Tests
Background
On Feb 25th, the Federal government implemented a stress test on our country’s 19 largest banks – not to see if one of these banks will fail, that was never a concern – but to see if a bank will prosper and proactively contribute to our country’s recovery, if we encounter more dire economic conditions. It was essentially asking one general question – will the bank still be able to lend to customers, and help our economy, if we encounter huge, unlikely losses due to extreme economic conditions?
Details
Specifically, the bank holding companies were asked to project their credit losses and revenues for the two years 2009 and 2010, including the level of reserves that would be needed at the end of 2010 to cover expected losses in 2011, under the two alternative economic scenarios: the “baseline scenario” and the “more adverse scenario”. The baseline scenario reflected the consensus expectation, as of February 2009, among professional forecasters, on the depth and duration of our country’s recession.
The more adverse scenario was designed to characterize a recession that is significantly longer and more severe than the consensus expectation. The firms were also asked to provide supporting documentation for their projected losses and resources, including information on projected income.
Banks that need to augment their capital buffers must develop a detailed capital plan by June 8 and implement that plan by Nov. 9.
A bank that needs a larger capital cushion to continue lending will have several options, including selling additional stock, converting preferred stock into common stock, or selling assets. A combination of these steps likely will enable banks needing more capital to avoid additional government investments.