Fed Releases Detailed Stress Test Instructions for Big Banks

WASHINGTON — The Federal Reserve Board on Friday issued detailed instructions to financial institutions ahead of the upcoming stress testing exercise that begins next week.

JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C: NYSE), and Wells Fargo (WFC) are among the 19 largest financial institutions that are expected to undergo the annual exercise intended to ensure banks hold sufficient amount of capital to withstand periods of economic stress.

"The Federal Reserve has been focused--and will remain focused--on ensuring the nation's largest financial institutions have enough capital to weather severe, unexpected conditions and still continue lending to households and businesses," Gov. Daniel K. Tarullo said in a press release.

Another 11 bank holding companies like BBVA USA Bancshares (BBVA), Discover Financial Services (DFS), and Northern Trust Corporation (NTRS), which have $50 billion or more in assets will also partake in the Fed's exercise.

The Dodd-Frank law requires the central bank to conduct regular stress tests on systemically important firms, including bank holding companies with more than $50 billion of assets.
Every fall, starting this November, the Fed will give the institutions under their watch multiple hypothetical scenarios — including relatively stable, adverse and "severely adverse" conditions — to set a basis for their tests.

Previously, banks only had to conduct stress tests under a stable and "severely adverse" conditions. The first reports with test results for the largest institutions will be due Jan. 7.

The Fed has said financial firms will be expected to have "credible plans” that show their ability to continue to lend to households and businesses even under severely adverse conditions, while still meeting a new set of capital requirements under Basel III.

"Capital is important to banking organizations, the financial system, and the broad economy because it acts as a cushion to absorb losses and helps to ensure that any such losses are borne by shareholders, not taxpayers,” according to the agency's release.

Each firm's capital adequacy will be assessed against a number of "quantitative and qualitative criteria” such as the bank's likely performance under stress test scenarios provided by the Fed along with the firm's own internal scenarios.

The board of directors at each firm is required to review and approve capital plans before submitting to the Fed.

Since the second quarter of 2012, the 19 firms have increased their total Tier 1 common capital to $803 billion from $420 billion in the first quarter of 2009. As a result, Tier 1 common ratios for these firms has more than doubled to a weighted average of 10.9% from 5.4%.

The Fed is not expected to release scenarios that will be used in the stress test until 4 p.m. E.S.T. on Nov. 15. However, regulators wanted to provide firms with ample time to begin the process.

"The Federal Reserve wanted to give firms as much time as possible to prepare their submissions and therefore is issuing the instructions ahead of the release of the macroeconomic and financial market scenarios,” the agency said.

The 19 firms will be allowed to make a "downward adjustment” to their initial planned capital distribution, before the Fed makes a final decision.

"The Federal Reserve will approve dividend increases or other capital distributions only for companies whose capital plans are approved by supervisors and who are able to demonstrate sufficient financial strength to continue to operate as financial intermediaries under stressed macroeconomic and financial market scenarios, even after making the planned capital distributions,” the agency said.

Like last year, the Fed will publicly release a summary of the results of the 19 firms, including projections of their capital ratios, losses, and revenues under the board's "severely adverse scenario."

Additionally, the agency will release two sets of post-stress test data for each firm. The first will include the capital distribution assumptions prescribed in the stress testing rule under Dodd-Frank, while the other will include ratios based on the firm's own capital distribution plans specified in their initial capital plan along with the ratios based on any changes made to those capital distributions.

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