U.S. banks are adequately capitalized but the Federal Reserve wants them to hold excess capital in case the economy deteriorates in the next two years, according to a paper addressing the design and implementation of the Fed's stress test.
However, bank reserves have been "substantially reduced," the Fed said. "Most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized."
In an effort to improve transparency and confidence in the banking system, the Fed ordered stress tests of the 19 largest financial institutions in the United States in order to ensure they are strong enough to withstand a further substantial decline in the economy. Banks will be asked to create buffers for losses through 2011 based on a worse-than-expected economic outlook.
The Federal Reserve said bank holding companies need to hold a "substantial" amount of capital above regulatory requirements in case the economy deteriorates. The Basel II international accords mandate that banks hold 8% in Tier 1 capital.
The paper released Friday showed that the economic assumptions used by the Fed were decided upon in February, but appear optimistic because of the recent weakness in the economy. The Fed noted that "the economy has deteriorated somewhat and professional forecasters have revised their outlooks for GDP growth and the unemployment rate in 2009 and 2010."
The Federal Reserve uses a baseline of -2.0% GDP growth in 2009 and +2.0% in 2010, which compares to the current -2.5% and +1.85% consensus estimates. The alternative, more averse scenario suggests -3.3% growth in 2009 and +0.5% growth in 2010.
The Fed's baseline is for 8.4% unemployment in 2009 and 8.8% in 2010. The alternative, more adverse scenario is 8.9% this year and 10.3% next year. The current consensus estimates are 8.9% (the same as the adverse scenario) and 9.40%.
The Fed uses a 14% drop in housing prices in 2009 and 4% in 2010 as a baseline. The more averse scenario suggests a 22% drop in 2009 and 7% decline in 2010.
"New information on house prices suggests that the market's expectation for house price declines is similar to what was anticipated in February," the paper said.
Market watchers are noting that Citi used all the 'more adverse' figures in February in their internal stress test criteria. Some are suggesting that since it appears banks already know the criteria, they may have been able to estimate the capital needed months ago.
Officials at the White House said they are inclined to be transparent about the releases. They added that some banks will release their own stress test results, while the government will release others.
By Adam Button and edited by Stephen Huebl
©CEP News Ltd. 2009