REUTERS

(REUTERS)

Banks Want More Tailored Approach to Stress Tests

Features Reuters

When U.S. auto lender Ally Financial Inc failed a key regulatory test two years ago, its executives were surprised to learn that the main reason was that the Federal Reserve treated loans to car dealers just like riskier credit to energy producers or manufacturers.

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The Fed's annual stress tests assess how banks would be affected by potential economic shocks, such as a spike in unemployment or a stock market slump. They require lenders to project losses on various loans and operations using a standard yardstick, which then the Fed uses to judge the resiliency of the entire financial system.

But behind the scenes, many big banks have been pushing back against the Fed's approach, arguing that it does not sufficiently account for the variety of business models, bank officials say. Banks have taken issue with such aspects of the Fed's methodology as using uniform tax rates and commercial loan loss rates that do not reflect the industry's diversity, bankers say.

"We felt like in some areas very broad approaches were being taken when maybe it should be a bit more tailored," Ally Financial finance chief Chris Halmy told Reuters in an October interview.

A Federal Reserve spokesman declined to comment about the upcoming results due on March 5 and March 11, or the merits of its approach.

The results and follow-up discussions between bankers and regulators, however, may offer some clues on how much success bankers had in persuading the Fed to modify its methodology.

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The stakes are high.

The annual tests, launched in 2011 under the 2010 Dodd-Frank financial reform bill, determine how much capital banks can use for dividends or stock buybacks and bankers have been struggling with what they say is an confusing process.

Citigroup Inc failed the 2012 and 2014 tests, while JPMorgan Chase & Co and Goldman Sachs Group Inc were both criticized for their operational processes and only received conditional approvals in 2013.

Goldman Sachs CEO Lloyd Blankfein told an industry conference last month the tests have become "too stressful."

To address that, executives from many top banks have been taking the unusual step of meeting informally to compare notes on what issues regulators were scrutinizing during the stress testing process. [ID: nL2N0TP1GY]

OVERLOOKING DIVERSITY

One example of what bankers describe as an overly broad approach to the process is the Fed's use of one uniform tax rate across all institutions, according to people familiar with the matter.

Such an assumption ignores the reality that banks' taxes vary widely depending on how much of their business is abroad, how many tax-free bonds they own, how many low-income housing tax credits they have on their books, and other factors. Bankers argue that overlooking such differences distorts the view of banks' earning power.

The Fed has taken some steps to better reflect the industry's diversity. For example, only banks that have large securities and derivative trading operations have to factor in how a global market shock and the default of a major counterparty would affect them.

But Fed regulators may be reluctant to go much further than that in responding to banks' calls for a more differentiated approach.

International capital rules allow banks to use their own models to assess risks, on the theory that every bank has different assets, and no one knows that makeup of its books better than the bank itself. However, banks use so many different methods that the Fed views its own stress-testing process as more informative. [ID: nL1N0OL1AS]

The Fed also deliberately keeps lenders in the dark about how it will model their performance to prevent banks from finding loopholes in the process that would allow them to take more risks, senior regulators have said publicly.

In the case of Ally Financial in 2013, its officials learned only after the test results that the Fed estimated potential losses on a portfolio of loans to auto dealers using a model for commercial and industrial loans, according to a person familiar with the matter.

That raised the projected loss rates on Ally's portfolio to more than seven times their actual level during the financial crisis, Ally Financial executives said at the time and called the Fed's analysis "fundamentally flawed." As a result, Ally, then majority-owned by the U.S. Treasury, failed the test, which complicated its efforts to exit government ownership. (Editing by Lauren Tara LaCapra and Tomasz Janowski)