By Steven K. Beckner
(MNI) – Federal Reserve Governor Daniel Tarullo suggested Tuesday
that the bank capital “stress tests” conducted last Spring be
“regularized” and made a continuous and fairly frequent requirement for
financial institutions.
Tarullo also argued that there is a need for more “external” and
“dissident” input into the financial supervisory process.
As part of their response to the financial crisis in early 2009,
the Fed and fellow banking supervisors instituted the Supervisory
Capital Assessment Process or SCAP, under which the 19 largest banking
organizations had to do “stress tests” on whether they had sufficient
capital to withstand a worse-than-forecast economic scenario.
Ten of the 19 were found to need an additional $75 billion in
capital.
New York Fed President William Dudley recently said SCAP “allowed
supervisors to ensure that the collective results of the individual
banks were consistent with a top-down assessment of revenue and credit
losses generated from an adverse stress scenario for the macroeconomy.”
Tarullo said SCAP-type stress tests should become a routine feature
of the supervisory process in remarks prepared for the Council of
Institutional Investors in Washington, D.C.
“I think that regularizing both stress tests and the release of
information relevant to them deserves serious consideration for at least
two reasons,” he said.
“First, …. releasing such information could assist investors in
the difficult task of valuing loan portfolios that at present are not
very transparent,” he said. “Second, releasing details about
assumptions, methods, and conclusions would expose our supervisory
approach to greater outside scrutiny and discussion.”
“Whether the result is critique or validation of our approach, the
reaction of informed investors and analysts to our assumptions and
methods would be beneficial,” Tarullo added.
Tarullo acknowledged some potential pitfalls of increasing the
transparency of stress test results. “In economic times more normal than
those prevailing when we conducted the SCAP, market participants will
not be fearing the worst and banks will not have access to government
capital injections as a backstop.”
“At such a moment, the revelation that some major banks may have
capital needs under a stress scenario might be unnecessarily
destabilizing, though the possibility of this kind of market reaction
may be lower if such information is released frequently,” he continued.
But Tarullo said “major unpleasant surprises would be less likely
with frequent, detailed disclosures.”
The Fed Board’s lone Obama appointee went on to advocate
“institutionalizing opportunities for external voices, including
dissident voices” as “an important element of macroprudential
supervisory efforts.”
“Outside critics are not always right, of course,” he said. “But
the best way to separate insightful and well-grounded criticisms from
unfounded ones is through a rigorous discussion in which the views of
outside critics, as well as those of the regulators themselves, will be
subject to inquiry.”
Tarullo said “such a process may lead to uncomfortable moments for
regulators, but that is a small price to pay if it can help contain
financial instability in the future.”
The Fed has already taken steps to incorporate non-governmental
views into the regulatory system. For instance, it has created the
quantitative surveillance mechanism (QSM), which Tarullo said “will use
market-based indicators such as stock prices, option prices, credit
default swap spreads, and short-term funding costs to provide an
external perspective on the condition of these institutions–one that
will be formally presented to regular meetings of senior supervisory and
other Federal Reserve staff.”
“Market-based indicators of macroeconomic and financial market
risks that could pose threats to the largest institutions also will be
used to assess their condition,” he said.
But Tarullo suggested more needs to be done, saying “the relatively
undeveloped nature of macroprudential analytic and oversight functions
argues for extensive transparency by regulators and involvement of
non-regulators.”
If, as part of financial reform legislation making its way through
Congress, a council of regulators is created and charged with issuing
periodic financial stability reports, then Tarullo said “the public at
large will have ample opportunity to comment on the council’s analyses.”
“Personally, I would go further and establish an advisory committee
that would assess not just the stability report, but other
macroprudential evaluations such as scenarios used in stress testing,”
he said. “By formalizing this activity, senior regulatory officials
would be required to confront and respond to the critiques directly, an
exercise that would help develop the embryonic function of
macroprudential oversight.”
Tarullo did not comment on the economy or broach monetary policy
issues.
** Market News International **
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