Alert April 28, 2009

FRB Releases Methodology for Capital Assistance Program Stress Test

The FRB released a detailed description of the methodology used to conduct the “stress tests” under the Capital Assistance Program (“CAP”).  The CAP is the component of the Obama administration’s Financial Stability Plan that allows banking organizations access to further capital investments by the Treasury after undergoing a “stress test” to determine whether additional capital would be needed under certain adverse economic scenarios.  Participation in the CAP is mandatory for the 19 largest U.S. financial organizations with banks (“banking organizations”), those with assets in excess of $100 billion.  The results of the stress tests conducted on these banking organizations is scheduled to be released on May 4, 2009.  The FRB stated that any banking organizations directed to raise new capital as a result of the these tests should not be viewed as insolvent or unviable.  U.S. banking organizations with less than $100 billion in assets may voluntarily participate in the CAP, and would be subject to a similar stress test as the one described below.  For further discussion of the CAP, please see the February 25, 2009 Alert Special Edition. 

Under the stress tests, banking organizations were asked to project revenues and credit losses for 2009 and 2010, including the level of reserves that would be needed at the end of 2010 to cover expected losses in 2011, under two alternate economic scenarios.  The first, or “baseline,” scenario represents a consensus outlook and is based upon economic forecasts at the end of February 2009.  The second, or “more adverse,” scenario reflects a deeper and longer recession than the baseline scenario.  As factors, the Federal banking agencies provided the real GDP growth, civilian unemployment rate and residential home price assumptions for 2009 and 2010 to be used in the baseline and more adverse scenarios.  For the baseline scenario, this was a GDP growth rate of -2% in 2009 and 2.1% in 2010, an unemployment rate of 8.4% for 2009 and 8.8% for 2010, and a residential home price index change of -14% in 2009 and -4% in 2010.  For the more adverse scenario, this was a GDP growth rate of -3.3% in 2009 and 0.5% in 2010, an unemployment rate of 8.9% for 2009 and 10.3% for 2010, and a residential home price change of -22% in 2009 and -7% in 2010.  The FRB noted that economic forecasters have revised their outlooks downward since February, however, the FRB believes that the more adverse scenario continues to account for a more negative economic downturn than the current consensus opinion.

Each participant in the CAP was instructed to project potential losses on its loan, investment and trading securities portfolios, including off-balance sheet commitments and contingent liabilities  and exposures.  The participating banking organizations were provided with a common set of indicative loss rate ranges for twelve specific loan categories under each of the two economic scenarios.  A banking organization could deviate from such loss rate ranges if it could provide evidence that its estimates were appropriate.  In addition, firms with trading assets of $100 billion or more were asked to estimate potential trading-related market and counter-party credit losses under a market stress scenario based on the market shocks that occurred in the second half of 2008.  Each participant was also asked to project its pre-provision net revenue – net interest income, fees and other non-interest income net of non-credit related expenses – and its allowance for loan and lease losses established as of December 31, 2008.  These projections, combined with existing capital above the amount sufficient to exceed minimum regulatory capital standards, comprised the resources available to absorb capital losses under the economic scenarios. 

Each banking organization also reported projections of Tier 1 capital and common shareholders’ equity for the end of 2009 and 2010.  The projected changes in the levels of capital projected by each banking organization over each of the scenarios reflects a combination of credit losses, pre-provision net income to absorb such losses, and the need to generate an appropriate allowance for loan and lease losses at the end of 2010.  The Federal banking agencies projected pro forma capital for 2010 for each banking organization using the revised estimates of credit losses and revenue.  No projection was made of any changes in capital participation by private investors or the Treasury.  The FRB stated that it did not rely on any single indicator of capital to determine the necessary capital buffer, rather it examined a range of capital indicators, including pro forma equity capital, Tier 1 capital and the composition of capital.  The FRB noted that the Federal banking agencies have long indicated that common equity should be the dominant component of Tier 1 capital and thus they examined the level of voting common shareholders’ equity for each banking organization.  The FRB did not release any specific capital threshold that must be met under the stress tests.