Oversight Panel Says Ongoing Stress Tests Needed

In light of worsening economic conditions, the Federal Reserve Board should continue to conduct stress tests of the nation’s largest bailed-out banks, a congressional panel said.

The Congressional Oversight Panel, while complimentary of the stress tests conducted earlier this year on 19 major banks, said that an unexpected increase in unemployment meant that the tests were already outdated.

The original stress tests projected the health of those banks under various levels of future economic distress. In the worst-case scenario, the tests assumed a 2009 unemployment rate of 8.9 percent. In May, however, the yearly average reached 8.5 percent, and if current trends continue, it will exceed previous assumptions.

Nine of the banks that underwent stress tests were found to hold sufficient capital. Ten of the banks were order to raise additional capital, and many have moved aggressively to do so by initiating stock offerings.

To better understand the stress tests, the panel hired two financial risk management experts to review the Treasury’s methodology.

The researchers, Professor Eric Talley and Professor Johan Walden, both of the University of California at Berkeley, 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” the banks face moving forward.

Professors Taley and Walden noted, however, that it was not possible to replicate the stress tests. The Federal Reserve has not disclosed whether it made different assumptions for different banks, and there is no way to check the reliability of the self-reported data that the banks provided to the government in advance of the 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,” the report says. “It may fail to capture substantial risks further out on the horizon.”

Moving forward, the oversight panel suggested that the Federal Reserve continue to conduct stress tests on a regular basis. It also said that banks should conduct their own stress tests and provide the results to regulators, and that regulators should have the ability to order stress tests whenever “they believe that doing so would help to promote a healthy banking system.”  

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