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

The Lessons of the SCAP

As I suggested at the outset of my remarks, I doubt that anything
as ambitious as the SCAP would have been tried — at least as soon as it
was — but for the exigencies of the financial crisis. Yet the approach
we took in the SCAP was informed by discussions that had been taking
place among supervisors and academics for some time. Not surprisingly,
against the backdrop of the crisis, the SCAP experience elaborated and
confirmed principles that had been advocated internally by some
supervisors, but that had not been broadly incorporated into the
practice of regulatory agencies. First, whether conducted by banks or
supervisors, stress tests must consider severe but plausible scenarios,
including low probability events with potentially highly adverse
effects. In the period leading up to the crisis — characterized by
strong profits, excess liquidity, and low credit losses — too many
banks and regulators were skeptical of the possibility of a rapid and
severe deterioration such as ultimately occurred in the U.S. housing,
mortgage, and short-term funding markets. If the crisis taught us
anything, it is that we must test to the tail, not to the mode. A
related point is that a stress test will be most useful if applied to
the full range of credit and trading exposures. Second, good
management-information systems are critical to the ability of firms to
manage their risks. Assessing risk exposures across an entire
organization is essential to understanding the potential effect of
correlated risk exposures that may reside in distinct business lines as
well as different legal entities and regulatory jurisdictions. Yet
during the SCAP, many of the banks were unable to quickly and
consistently consolidate risk exposures across products, business lines,
legal entities, and geographies. It does little good to run a stress
test, even one using a sophisticated quantitative model, if it does not
effectively capture all relevant exposures because the banks
information systems are poorly managed or integrated.

(GMAC did receive a capital injection from the Treasury through the
TARPs Automotive Industry Financing Program.)

Third, the SCAP highlighted the importance of having multiple
inputs into the risk-assessment process. It was critical to have, and
use, the best available data. But it was equally important not to become
a slave to any one model or method of estimating losses. It was
precisely the combination of rigorous, data-driven analyses and
considered judgment that made the stress test successful. The
interactive and iterative nature of the process helped refine each
method of assessment.

Fourth, the SCAP underscored the importance of both horizontal and
macroprudential perspectives in supervising banking organizations.
During the SCAP, simultaneous, consistent, and comparative cross-firm
assessments allowed a broader analysis of risks, easier identification
of outliers, and better evaluation of individual firm estimates. Because
SCAP banks held the majority of U.S. banking assets, it also allowed for
a better understanding of interrelationships and systemic risks. Turning
now to how the SCAP experience has informed our supervisory policies, I
think its effects are best understood in the overall context of the
reforms motivated by the financial crisis. Like regulators around the
world, we are developing and implementing improvements in capital and
other prudential rules. The Congress is considering legislative
proposals to enhance market discipline through such means as a special
resolution mechanism for large financial firms and to affect the
structure of the financial services industry through such measures as
the Volcker rule and limitations on acquisitions by systemically
important firms. These three modes of reform — rules, market
discipline, and structural measures — must be complemented by
more-effective supervisory oversight, particularly of the largest, most
complex financial institutions. To this end, the Federal Reserve is now
implementing a more closely coordinated supervisory system in which a
cross-firm, horizontal perspective is an organizing supervisory
principle. We will concentrate on all activities within the holding
companies that can create risk to the firm and the financial system, not
just those that increase risk for insured depository institutions.

An essential component of this new system will be a quantitative
surveillance mechanism for large, complex financial organizations that
will combine a more macroprudential, multidisciplinary approach with the
horizontal perspective. Quantitative surveillance will use supervisory
information, firm-specific data analysis, and market-based indicators to
identify developing strains and imbalances that may affect multiple
institutions, as well as emerging risks to specific firms. Periodic
forwardlooking scenario analyses will enhance our understanding of the
potential effects of adverse changes in the operating environment on
individual firms and on the system as a whole.

In fact, I believe that the most useful steps toward creating a
practical, macroprudential supervisory perspective will be those that
connect the firm-specific information and insight gained from
traditional microprudential supervision to analysis of systemwide
developments and emerging stresses. Here, precisely, is where our SCAP
experience has helped lead the way.

The Question of Transparency

One important element of the SCAP that has not yet been
incorporated into our ongoing supervisory plans is the public disclosure
of stress test information. I think this issue deserves consideration.
As I recently testified, access to higher-quality and moretimely
information about financial products, firms, and markets is necessary
for effective supervision.

Making data public — to the degree consistent with protecting
firm-specific proprietary information — would have additional benefits.
In the specific context of greater transparency in supervisory stress
tests, I see at least two. First, the release of details about
assumptions, methods, and conclusions would expose the supervisory
approach to greater outside scrutiny and discussion. Sometimes those
discussions will help us improve our assumptions or methodology. At
other times disclosure might reassure investors about the quality of the
tests. Either way, the publics reaction to our assumptions and methods
would be useful.

Second, because loan portfolios are inherently difficult to value
without a great deal of detailed information, increased transparency
could be an important addition to the information available to investors
and counterparties of the largest institutions. If, as I believe,
progress on the too-big-to-fail problem is integral to an effective
reform of financial regulation, we must enhance market discipline. The
market discipline made possible by such means as special resolution
mechanisms and contingent capital will be most effective if market
participants have adequate information with which to make informed
judgments about the banks.

There are, to be sure, countervailing concerns. In more normal
economic times, when market participants are not fearing the worst and
when banks do not have access to government capital injections as a
backstop, the revelation that some major banks may have capital needs
under a stress scenario might be unnecessarily destabilizing. This
possibility would be increased if market participants attached undue
weight to specific capital or loss numbers released by the government.

In practical terms, there are several ways we might increase transparency. One, of
course, would be to follow the SCAP precedent, with periodic release of detailed
information about the assumptions, methods, and results of a cross-firm, horizontal,
forward-looking exercise, including firm-specific outcomes. This approach would
probably maximize both the potential benefits and potential risks. Note, however, that
the possibility of a destabilizing market reaction may be lower if such information is
released frequently, as major unpleasant surprises would be less likely with frequent,
detailed disclosures. Of course, significant changes in the economic environment might
still lead to unpleasant surprises when the results are released.

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

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