The Congressional Oversight Panel – the body chaired by Elizabeth Warren and which has repeatedly criticised the US government’s handling of the financial crisis – released a report on Tuesday that (shock!) criticised the bank stress tests conducted by the Fed.
In its 168-page report, the COP warned that the scenarios under which the stress tests were carried out were not stringent enough, even if the model was generally “conservative and reasonable.”
From the report (emphasis FT Alphaville’s):
Based on the available information, the professors found that the Federal Reserve used a conservative and reasonable model to test the banks, and that the model provides helpful information about the possible risks faced by BHCs and a constructive way to address those risks. The criteria used for assessing risk, and the assumptions used in calibrating the more adverse case, have typically erred on the side of caution and avoided many of the more dangerous simplifications present in some risk modeling.
The professors also raised some serious concerns. They noted that there remain unanswered questions about the details of the stress tests. Without this information, it is not possible for anyone to replicate the tests to determine how robust they are or to vary the assumptions to see whether different projections might yield very different results. There are key questions surrounding how the calculations were tailored for each institution and questions about the quality of the self-reported data.
It is also important to note that the stress test scenarios made projections only through 2010. While this time frame avoids the greater uncertainty associated with any projection further in the future, it may fail to capture substantial risks further out on the horizon. Based on the testimony by Deutsche Bank at the Panel’s May field hearing, the projected rise in the defaults of commercial real estate loans after 2010 raise concerns.
As is its wont, the Panel also offered “several recommendations for consideration moving forward”:
• The unemployment rate climbed to 9.4 percent in May, bringing the average unemployment rate for 2009 to 8.5 percent. If the monthly rate continues to increase during the remainder of this year, it will likely exceed the 2009 average of 8.9 percent assumed under the more adverse scenario, suggesting that the stress tests should be repeated should that occur.
• Stress testing should also be repeated so long as banks continue to hold large amounts of toxic assets on their books. • Between formal tests conducted by the regulators, banks should be required to run internal stress tests and should share the results with regulators.
• Regulators should have the ability to use stress tests in the future when they believe that doing so would help to promote a healthy banking system.
The COP also called for additional transparency, saying the Fed should release more information on the results of tests and more details about the methodology “so that analysts can replicate the tests under different economic assumptions or apply the tests to other financial institutions.”
And finally:
the Panel cautions that banks should not be forced into counterproductive “fire sales” of assets that will ultimately require the investment of even more taxpayer money. The need for strengthening the banks through capital increases must be tempered by sufficient flexibility to permit the banks to realize full value for their assets.
Related links:
Ten US banks to repay Tarp funds – FT