WASHINGTON — The biggest banks got a clearer picture Monday of what to expect when the Federal Reserve Board releases its latest stress tests results later this week.
Shortly after the market's close, the Fed disclosed a 39-page methodology paper along with the templates that will be used to detail the results of a rigorous round of stress testing on the 19 largest bank holding companies in order to assess their ability to issue dividends to shareholders during severe economic periods.
"Strong capital levels are critical to ensuring that banking organizations have the ability to lend and to continue to meet their financial obligations, even in times of economic difficulty," the Fed said.
Firms — including Bank of America Corp., JPMorgan & Chase & Co., Wells Fargo & Co. and Citigroup Inc., all of which submitted plans in early January — will be evaluated on an individual basis as well as by comparison, according to the templates. The results will be released by the Fed on Thursday after the market's close at 4:30 p.m. EDT. At that time, banks will also be notified whether they "passed" and can move ahead with their capital distribution plans.
Banks have had to undergo stress tests before, but this round marks the first time since the financial crisis that the results will be made public — and it is arguably the most severe version of the test, given the harsh variables that banks had to score themselves against.
"Given continued general economic uncertainty at the time that the scenario was designed in November 2011, including the on-going situation in Europe and continued stress in mortgage markets, the Federal Reserve believed it was prudent to provide an adverse scenario that was sufficiently severe to ensure a rigorous assessment of the bank holding company's ability to withstand unexpected losses," the Fed wrote in its paper.
Those variables included projecting a bank's condition if unemployment jumped to 13% (it is currently at 8.3%), the Dow Jones Total Market Index fell to 5,700 points and a sharp decline of gross domestic product to minus-8%.
Six of the firms were also asked to run a global market shock scenario that replicates similar events that occurred during the second half of 2008.
The Fed explained it's rational for releasing the stress scenario projections ahead of the results was to "enhance transparency" of the exercise. In 2009, it took a similar step issuing a paper outlining its plans and putting out a statement from regulators.
In the paper, regulators made it a point to say they were cautious in their stress scenarios often using "conservative assumptions," which they explained tend to "reduce projected levels of regulatory capital" and also tend to generate "higher projections of losses and lower projections of revenues."
Results disclosed on Thursday will include projected capital ratios over nine quarters through the end of 2013, including Tier 1 common capital, risk-based capital and leverage. It will also include pre-provision net revenue, as well as trading and counterparty losses.
As previously anticipated, banks will also have to disclose projected loan losses on a yearly basis for six categories, including first lien mortgages, commercial and industrial loans and credit cards.
The Fed will also provide for each bank its individual minimum stressed ratio after the first quarter of 2012 (not including any capital distributions completed before the end of first quarter) and a minimum stressed ratios with all proposed capital actions through fourth quarter of 2013.
Banks have been uncomfortable with the amount of information being disclosed to the public. An equally important concern is the type of adjustments the Fed would potentially make to its data without sharing that information with the individual banks before it is released publicly.
Regulators attempted to assuage some of those fears by stating in its paper areas where it did make such adjustments, though it did not disclose for which banks this would apply to. For example, the Fed said it adjusted pre-provision net revenue whenever the projections "lacked sufficient support or were deemed inconsistent" with the stress exercise.
The Fed said in its projections it used substitutes for certain elements like mortgage repurchase and put-back costs for certain banks.
It also sought to explain to banks the types of models it used to project losses on loans like commercial real estate and residential mortgages.
Given the negative headline risk, the Fed emphasized the number of reasons it could deny a firm's capital plan, including its progress in meeting regulatory capital standards under Basel IIII. It also added that loss projections, revenue and expenses under stress scenarios wouldn't be the only consideration weighed by the Fed, and may not be the deciding factor in all cases.