The Federal Reserve, releasing details of how it conducted "stress tests" on the nation's 19 largest financial institutions, said “most banks currently have capital levels well in excess of the amounts needed to be well capitalized."
But the banks need to hold a "substantial" amount of capital above regulatory requirements to weather a potential worsening of the economic recession, the eagerly awaited report said.
The report said the tests are a “forward-looking exercise designed to estimate losses, revenues and reserve needs” under two different macroeconomic scenarios, including an adverse one.
According to the report, the "banks were asked to project their credit losses and revenues for two years."
The process "involves the projection of losses on loans, assets held in investment potfolios and trading-related exposures, as well as the firm's capacity to absorb losses in order to determine a sufficient capital level to support lending."
The stress tests included two economic scenarios. In terms of the unemployment rate, the worse case was assumed to be 10 percent, housing prices are assumed to be 10 percent lower at the end of 2010 than the more likely baseline scenario. The baseline jobless rate averages 9.8 percent.
In terms of GDP scenarios, the stress tests assume baseline levels of minus 2 percent in 2009 and plus 2.1 percent in 2010.
The adverse scenario levels are negative 3.3 percent this year and growth of just 0.5 percent next year The tests also ask banks to provide projections of "resources available to absorb losses under two scenarios" over a two-year period.
The tests also ask banks to provide projections of "resources available to absorb losses under two scenarios" over a two-year period.
Reaction to the criteria and methodology of the tests was muted.
James Paulsen of Wells Capital Management, for instance, was underwhelmed.
Paulsen says he "didn't have great expectations" in the tests, and was expecting to "find out most the banks are OK, which is what we knew going in."
Rep. Brad Sherman (D-Calif.) called the tests "a good idea to evaluate the strength of the banks and publicize it" because "there is anxiety out there."
The government last week announced a two-stage disclosure process, wherein the test criteria would be outlined today and the actual test results on May 4.
The tests are meant to see how the institution's balance sheets can hold up under a number of economic and financial circumstances, including a deterioration of the current recession. That would include the unemployment rate, which would would lead to higher mortgage delinquencies and home foreclosures.
CNBC has reported on several occasions since the tests were announced in February that one of the capital criteria preferred by the government is tangible common equity. TCE essentially measures the book value of common shares, excluding such intangibles as goodwill and deferred taxes. The target level is thought to be 3 percent of so-called risk-weighted assets.
The tests—performed on the 19 largest financial institutions—have been something of a political hot potato for the Obama administration, since they were first announced in February as the Treasury was outlining the various parts of its financial stability plan.
There's also been widespread speculation about the banks involved, but based on assets, loan portfolios and other key measures, it would certainly include Citigroup , Bank of America (NYSE: BAC) , JPMorgan Chase (NYSE: JPM), Wells Fargo (NYSE: WFC) and other big firms that have received TARP funds.
The introduction of a new closely-watched capital metric, which the Treasury has previously said it did not intend to do, would be significant.
Under current banking regulations, the capital requirements of banks are based on Tier 1 and Tier 2 ratios, which measure capital against risk-weighted assets.
Tier 1 is the more important of the two and basically consists of shareholder equity, retained profits and good will, minus accumulated losses. Banking analysts say the industry prefers the Tier-1 metric.
Though the administration said the tests were not "pass/fail", many in the markets say they will inevitably lead to a perception of winners and losers within the industry, with the weaker banks becoming suspect, which could depress their stock prices.
The tests will be used to decide which firms are under capitalized. Regulators will then ask the banks to raise private capital over the next six months. If unsuccessful, the institution will be eligible for new capital injections through the Treasury's capital access program, or CAP.
That program comes with a number of controversial stipulations, including limits on executive compensation and rigorous reporting rules.
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