Fed Weighs Using Bank Stress Tests for Crisis Prevention

By Michael Flaherty and Howard Schneider

WASHINGTON -- The Federal Reserve is considering turning its annual health check for big banks into one of the tools it could use to prevent a build up of excessive financial risks.

If deployed, the modified tests could force banks to retain billions of dollars that otherwise would have gone to shareholders. While the move would help cool off sectors at risk of overheating, it could spark the ire of bank executives, who complain of rising regulatory burdens.

Since 2009, the Fed has conducted the so called stress tests on the largest U.S. banks to judge whether they have enough capital to survive economic downturns and market turmoil.

%VIRTUAL-WSSCourseInline-963%But as the Fed ramps up its crisis-prevention ability, its officials are now discussing whether to shape the annual test to take aim at particular markets or sectors to address risks to the whole economy, according to people familiar with the matter.

"Suppose you were concerned about a housing bubble. In the stress test scenario, you can put a bigger housing collapse into it," one of the people told Reuters. "For example, the test assumes housing prices are going to collapse by 50 percent instead of by 30 percent."

In its present form, the stress tests focus on important financial institutions' ability to withstand economic shocks. The new approach, if adopted, would allow the Fed to modify test scenarios to focus on potential trouble spots and make banks take precautions that would protect not just them but the entire financial system.

The tests apply to the 30 largest institutions operating in the United States, including JPMorgan Chase (JPM), Citigroup (C) and Goldman Sachs (GS) and Bank of America (BAC). Banks that fail the test may be told to scrap share buy backs or cut dividend payouts. Citigroup's failure to pass a portion of the annual test earlier this year forced it to give up a planned $6.4 billion share buy back and a dividend rise.

Subprime Shadow

Behind the Fed's increasing focus on stability is the memory of its failure to prevent the 2007-2009 subprime mortgage market meltdown. It is also concerned that the Financial Stability Oversight Council established by Congress after the financial crisis is too unwieldy to quickly head off new economic threats.

Fed Vice Chairman Stanley Fischer, who leads the Fed's new financial stability committee, highlighted in July the contrast between the U.S. body that coordinates work of 10 government agencies and the Bank of England's powerful Financial Stability Panel with its legal power to impose policy changes on regulators.

An official at the U.S. Treasury, one of the Council's members, told Reuters that it takes a long time for the panel to act even if risks become apparent.

"You might see something ... but getting in there is hard to do quickly."

Basel III international bank standards also allow central banks to apply a so-called counter cyclical capital buffer and a surcharge on systemically important financial institutions as preventative measures. Both could force banks to raise tens of billions of extra capital, denting returns for investors.

For now, however, the focus at the Fed seems to be on the stress test as its key financial stability tool.

"Stress testing ... I think holds great promise as a capital tool, a risk sensitive capital tool, for big institutions, but also taking a macroprudential look because of the multiple scenarios that apply to everybody," Fed governor Daniel Tarullo said at an economic forum Saturday. Tarullo sits on the Fed's new financial stability committee.

A central bank can attempt to cool financial markets by raising interest rates, but Fed chief Janet Yellen has said such a blunt tool should be used only as a last resort.

Instead, central bankers prefer so-called macroprudential measures that aim to curb excessive risk-taking by financial institutions or consumers.

"To my mind, the best tool that we have is really the stress tests," San Francisco Fed President John Williams told Reuters this week, adding that he was not directly involved with the Fed's financial stability oversight. "Like mortgage lending. So if that's what your concern is today, you can have the stressed scenario be designed to include that aspect of potential system risk."

-With additional reporting by Douwe Miedema.