WASHINGTON (MNI) – The following is the text of Federal Reserve
Gov. Daniel Tarullo’s remarks Friday evening to the International
Research Forum on Monetary Policy:

Lessons from the Crisis Stress Tests

Effective responses to dire situations often require bold actions
that would be unthinkable in calmer times. So it was in the financial
crisis, when central banks undertook extraordinary monetary policy
measures and governments made major financial firms wards of the state.
Yet sometimes a crisis also accelerates adoption of policies and
practices that might beneficially have been implemented beforehand and
then are sensibly continued after the crisis has passed. This evening I
will examine an instance of this latter phenomenon, as defined by the
Federal Reserves experience with comprehensive stress testing of major
financial institutions during the crisis.

The Supervisory Capital Assessment Program (SCAP) was fashioned in
early 2009 as a key element of a crucial plan to stabilize the U.S.
financial system. The stress tests, as they have been popularly called,
required development on the fly, and under enormous pressure, of ideas
that academics and supervisors had been considering for some time. After
describing the concept, design, and implementation of last years tests,
I will explain how our experience has helped prompt major changes in
Federal Reserve supervision of the nations largest financial
institutions. Then I will discuss how this experience has stimulated
debate over the merits of publicly releasing supervisory information.

Origins and Execution of the Supervisory Capital Assessment Program
By February 2009, many steps had already been taken to restore the
health of, and confidence in, U.S. banks. The U.S. Treasury had injected
capital into banks under the Troubled Asset Relief Program (TARP). The
Federal Deposit Insurance Corporation had expanded guarantees for bank
liabilities under its Temporary Liquidity Guarantee Program. And the
Federal Reserve had established a number of lending programs to provide
liquidity to financial institutions in addition to its aggressive
monetary policy actions.

(The views expressed in these remarks are my own and not
necessarily those of other members of the Board of Governors.)

Despite these actions, a great deal of uncertainty remained about
future bank losses and solvency, which was only increased by the rapidly
deteriorating macroeconomic conditions in early 2009. The Treasury
determined that confidence could best be restored by making additional
capital available to banks that were unable to raise from private
sources the amounts necessary for them to continue to function as
effective financial intermediaries even if economic conditions worsened
appreciably. To evaluate how much capital individual institutions might
require, U.S. bank supervisors, led by the Federal Reserve, undertook a
stringent, forward-looking assessment of prospective losses and
revenues–a stress test–for the 19 largest U.S. banks. Using TARP
funds, the Treasury established the Capital Assistance Program (CAP) to
provide any needed capital.

Let me summarize the mechanics of the stress tests. First, in
February 2009, each of the SCAP banks was asked to perform a
capital-adequacy stress test under two economic scenarios — baseline
and more adverse — using specified assumptions for gross domestic
product (GDP) growth, unemployment, and house prices. The baseline
scenario reflected the consensus expectation among professional
forecasters on the depth and duration of the recession. The more adverse
scenario was designed to be severe but plausible, with a probability of
roughly 10 to 15 percent that each of the macroeconomic variables could
be worse than specified. The banks were asked to provide projections of
losses and revenues under the two scenarios. Losses were to be projected
over a two-year horizon for at least 12 separate categories of loans and
a few other asset classes, using year-end 2008 financial statement data
as a starting point. To guide the banks, supervisors provided indicative
loss-rate ranges for the system as a whole, derived from both analysis
of historical loss experience at large banks and quantitative models
relating loan performance to macroeconomic variables. Banks were
informed that loss estimates below the indicative range would be closely
scrutinized.

Second, the supervisory teams evaluated the banks estimates to
identify methodological weaknesses, missing information, overly
optimistic assumptions, and other problems. Examiners had detailed
conversations with bank managers, which led to numerous modifications of
the banks submissions. Supervisors then made judgmental adjustments to
the banks loss and revenue estimates based on sensitivity analyses
performed by the firms, comparative analysis across the firms, and the
supervisors own judgments.

Third, the supervisors supplemented these judgmental assessments
with objective, model-based estimates for losses and revenues that could
be applied on a consistent basis across firms. Each participating
institution was asked to supply, in a standardized format, detailed
information that supervisors could use to estimate losses and revenues,
such as details about loan characteristics. These data allowed
supervisors to make consistent estimates using independently constructed
models. Finally, supervisors systematically incorporated all of these
inputs into loss, revenue, and reserve estimates for each institution.
These estimates were combined with information on existing reserves and
capital to project capital buffers that the banks would need under the
two scenarios.

As you know, unlike other countries that conducted stress
exercises, we took the highly unusual step of publicly reporting the
findings of the SCAP, including the capital needs and loss estimates for
each of the 19 banks. This departure from the standard practice of
keeping examination information confidential was based on the belief
that greater transparency of the process and findings would help restore
confidence in U.S. banks at a time of great uncertainty. Supervisors
released the methodology and assumptions underlying the stress test
first and then, two weeks later, the results for individual
institutions. The results showed that under the more adverse scenario,
10 of the 19 SCAP banks would need to raise a total of $75 billion in
capital in order to have the capital buffers that were targeted under
the SCAP–Tier 1 capital in excess of 6 percent of risk-weighted assets
and Tier 1 Common capital in excess of 4 percent of risk-weighted assets
at the end of the two-year horizon.

The merits of publicly releasing firm-specific SCAP results were
much debated within the Federal Reserve. In particular, some feared that
weaker banks might be significantly harmed by the disclosures. In the
end, though, market participants vindicated our decision. They appeared
to be reassured for three reasons. First, the results were deemed
credible by most market participants, owing in part to the release of
details about our assumptions and methods, as well as the variation in
assessment of the banks. Second, the results were released at a time
when uncertainty about bank conditions was very high, and some market
participants feared the worst. That is, perceptions of tail risk were
very high, and the SCAP results helped reassure market participants that
under a severe but plausible scenario, the capital needs of the largest
U.S. banks were manageable. Third, the Treasury stood ready to make
capital available to any SCAP bank with capital needs through the CAP if
they were unable to raise private capital.

(Board of Governors of the Federal Reserve System (2009), “Federal
Reserve, OCC, and FDIC Release
Results of the Supervisory Capital Assessment Program,” press release,
May 7, www.federalreserve.gov/newsevents/press/bcreg/20090507a.htm.)

In retrospect, it is clear that the public release of the SCAP
results played an important role in stabilizing the financial system, as
has our supervisory follow-up on improving capital levels. By November
2009, the 10 banks that required additional capital had increased their
Tier 1 Common equity by more than $77 billion, primarily by issuing new
common equity, converting existing preferred equity to common equity,
and selling businesses or portfolios of assets. None of the SCAP banks
received CAP funds.3 Many observers initially criticized the stress
tests as overly optimistic. On the one hand, they noted that GDP growth
was weaker and unemployment higher in 2009 than projected in the more
adverse scenario. On the other hand, house prices did not fall as much
as assumed under the more adverse scenario. As of the end of 2009,
actual losses at the 19 banks were less than one-half of the two-year
loss estimates under the more adverse SCAP scenario, and actual revenues
were more than one-half of the two-year revenue estimates. Nevertheless,
there is wide variation across the firms, and it is too soon to tell
whether firms will perform better over the full two years than the SCAP
estimates.

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** Market News International Washington Bureau: 202-371-2121 **

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