Regulators conducting the stress tests on the 19 largest U.S. banks are increasingly focusing on the quality of loans the companies made after finding wide variations in underwriting standards, a regulatory official said.
Supervisors concluded that lending practices would need to be given as much weight as macroeconomic scenarios after finding a wide variation in standards for mortgages and other loans as about 200 examiners pored through the portfolios, the official said.
The expanded criteria for the assessments will allow regulators to identify how much of each bank’s vulnerabilities stem from the economy’s deterioration, and how much comes from management decisions. Treasury Secretary Timothy Geithner has said he’s prepared to make management changes in any firms requiring "exceptional" amounts of fresh taxpayer funding.
"There was a heavy assumption" that soaring loan defaults in recent months were caused by the recession, said Kevin Petrasic, who served at the Office of Thrift Supervision from 1989 to 2008 and is now an attorney at law firm Paul Hastings in Washington. "If they find out that these were business decisions, that, in an odd way, is probably a good sign because you can fix this. There are very hard lessons to be learned."
The official’s remarks provide insight into the release April 24 on the regulator’s methodology for the tests. Supervisors are addressing an error made two years ago when basing foreclosure projections on economic assumptions and concluding that poorly written loans may default regardless of the economy’s performance.
The person also said the tests don’t amount to solvency judgments, noting that estimates of each bank’s losses over the coming two years won’t necessarily equal the amount of new capital it needs to raise.
The goal of the reviews is to keep the major financial institutions lending over the next two years, and to determine how much capital they might need should the economic downturn worsen. Assumptions about capital will be forward-looking, the official said.
Supervisors will take into account how much capital each company has, the ability to retain earnings over the next years, access to private capital in the future and how aggressively they have already written down assets.
Federal Reserve officials are coordinating the exams, dedicating a staff of about 140 people to the effort. All told about 200 regulatory officials are involved, with information percolating up from front-line bank examiners.
While the tests are a central element of the Obama administration’s financial rescue plan, the Treasury charged the Fed, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp., and Office of Thrift Supervision to conduct them.
Some of the findings on how portfolio quality varied will be revealed April 24 when supervisors release the white paper on the methodology. Final results of the tests will be released May 4. No decision has been made on how to publish the results, with some regulators concerned about a lack of uniformity in the releases if each firm discloses its own results.
The methodology paper will discuss what supervisors describe as a propensity for loss among loan portfolios. Some categories of lending, such as credit cards, are highly correlated with macroeconomic data such as rising unemployment.
Bank of America, the largest U.S. lender, fell the most in almost two months in New York trading April 20 after putting aside $6.4 billion to cover a growing pool of uncollectible loans.