Fed Takes Lead Role in Executing ‘Stress Tests’ of U.S. Banks

By Craig Torres and Lizzie O’Leary

March 31 (Bloomberg) -- The Federal Reserve has taken the primary role in determining how much new capital the nation’s biggest banks need to weather the economic slump, people familiar with the matter said.

Putting the Fed in charge may help ease concern that different assessments by different agencies would lead to some firms being judged less strictly than others. Treasury Secretary Timothy Geithner has said he anticipates the results, due at the end of April, will result in “large” capital needs for some companies, offering investors a way of differentiating between weaker and stronger lenders.

Fed examiners are deployed alongside counterparts from three other agencies that oversee parts of the 19 banks that are involved in the so-called stress tests.

“You could argue this is a systemic risk issue and it is good to have another regulator step in and assert a uniform set of standards,” said Kevin Fitzsimmons, analyst at Sandler O’Neill & Partners LP in New York, and a former bank examiner at the Federal Reserve Bank of Boston. “The Fed has its hands on every institution that is a holding company.”

All 19 of the firms under scrutiny, from American Express Co. and GMAC LLC to SunTrust Banks Inc. and Citigroup Inc., are bank holding companies, giving the Fed an overarching role.

‘Consistency’ of Tests

Geithner unveiled the stress tests on Feb. 10. They were billed as a comprehensive set of standards for the financial system’s most important banks, regardless of their regulator. He stressed “consistency” and “realism” in congressional hearings that week.

While U.S. regulators don’t intend to publish the details of their stress tests, the results will effectively become known once it is determined how much capital each bank is required to raise. Under the terms of the February plan, firms will be given six months to raise the funds either from private investors or the government.

The tests are designed to mesh with the administration’s effort to remove distressed mortgage assets from banks’ balance sheets, which have hampered lending to consumers and businesses. Officials aim to have the first purchases of the toxic assets by private investors financed by the government within weeks of the conclusion of the capital-need assessments.

“Banks are going to have an incentive” to sell their devalued assets because they want to “go raise private capital from the markets,” Geithner said in an interview with NBC’s “Meet the Press” March 29.

Price of Assets

Still, it’s unclear whether most of the big banks will be willing to sell loans and securities at prices that may be below the current valuations on their balance sheets.

Bank of America Corp. Chief Executive Officer Kenneth Lewis said in a Bloomberg Television interview March 27 that the pricing of the assets is “going to be the key” determinant of his bank’s participation.

Citigroup CEO Vikram Pandit told reporters after a group of bank chief executives met with President Barack Obama March 27 that “we want to do whatever it takes” and work with officials “to promote a recovery.”

All of the 19 banks are bank or financial holding companies, according to the Federal Deposit Insurance Corp.’s Web site. Some of them have units overseen by the FDIC, Office of the Comptroller of the Currency and Office of Thrift Supervision.

OCC spokesman Kevin Mukri referred to prior Treasury statements noting that federal supervisors would coordinate in the tests.

OTS Ouster

Geithner removed OTS Acting Director Scott Polakoff last week amid concern about how the agency handled accounting for capital raised by banks it oversaw. John Bowman, the deputy director and chief counsel, was named acting director, becoming the third OTS chief so far this year.

The OTS failed to uncover “unsafe and unsound” practices at Pasadena, California-based IndyMac Bancorp Inc., an audit concluded last month. The Treasury’s inspector general disclosed on Jan. 30 that the OTS permitted IndyMac and four other unidentified lenders to improperly backdate a capital infusion, which helped them avoid regulatory restrictions.

“If these stress tests are going to be meaningful, as they should be, then banks are going to require more capital,” Patrick Cave, a former Treasury official who is now chief executive officer of Cypress Group LLC, said in an interview on Bloomberg Television. He added that the administration is right to pursue a “tough love” approach to any further assistance.

Economic Projections

Regulators’ assessments are based on two scenarios for the economy. The “baseline” forecast projected a 2 percent economic contraction and an 8.4 percent jobless rate in 2009, followed by 2.1 percent growth and 8.8 percent unemployment in 2010.

The “alternative more adverse” scenario had a 3.3 percent contraction in 2009, accompanied by 8.9 percent unemployment, followed by 0.5 percent growth and 10.3 percent jobless in 2010.

The Treasury estimates it has about $135 billion left in the $700 billion financial-rescue fund enacted in October. Banks who already received government funding also could get a capital boost if the Treasury agrees to convert its preferred shares into common equity. Obama administration officials haven’t said when they may need more rescue money and ask for congressional authorization.

To contact the reporters on this story: Craig Torres in Washington at ctorres3@bloomberg.net; Lizzie O’Leary in Medellin at loleary2@bloomberg.net