Ben S Bernanke: The Supervisory Capital Assessment Program
Speech by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal
Reserve System, at the Federal Reserve Bank of Atlanta 2009 Financial Markets
Conference, Jekyll Island, Georgia, 11 May 2009.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
My remarks this evening will focus on the Supervisory Capital Assessment Program,
popularly known as the banking stress test. The federal bank regulatory agencies began the
assessment program in late February and concluded their review with the release of the
results just last Thursday. This initiative involved an unprecedented, simultaneous
supervisory review of the 19 largest bank holding companies in the United States. Its
objective was to ensure that these institutions have sufficient financial strength to absorb
losses and to remain strongly capitalized, even in an economic environment more severe
than currently anticipated. A well-capitalized banking system is essential for the revival of the
credit flows that will underpin a sustainable economic recovery.
Objectives of Supervisory Capital Assessment Program
As you know, the abrupt end of the credit boom in 2007 has had widespread financial and
economic ramifications, including a sharp slowdown in global economic activity and the
imposition of substantial losses on banks and other financial institutions. Economic and
financial weaknesses have fed on each other, as a declining economy has exacerbated
credit losses and the resulting pressure on banks and other financial institutions has
constrained the availability of new credit.
A number of significant steps have been taken to restore confidence in the nation's financial
institutions, including a substantial expansion of guarantees for bank liabilities by the Federal
Deposit Insurance Corporation (FDIC), injections of capital by the Treasury in many
institutions both large and small, and Federal Reserve programs to provide liquidity to
financial institutions and support the normalization of key credit markets. These efforts
averted serious threats to global financial stability last fall and have contributed to gradual
improvement in key credit markets, though many markets remain stressed.
These steps, however, did not fully address market concerns over the depletion of bank
capital caused by write-downs and increased reserving for potential losses. At the beginning
of this episode, bank losses were focused in a few asset classes, such as subprime
mortgages and certain complex credit products. Today, following the significant weakening in
the global economy that began last fall, concerns have shifted to more-traditional credit risks,
including rising delinquencies on prime as well as subprime mortgages, unpaid credit card
and auto loans, worsening conditions in commercial real estate markets, and increased rates
of corporate bankruptcy.
The loss of confidence we have seen in some banking institutions has arisen not only
because market participants expect the future loss rates on many banking assets to be high,
but because they also perceive the range of uncertainty surrounding estimated loss rates as
being unusually wide. The capital assessment program was designed to reduce this
uncertainty by conducting a stringent, forward-looking assessment of prospective losses at
major banking organizations. The objective was to identify the extent to which each of the 19
firms is vulnerable today to a weaker-than-expected economy in the future, and to measure
how much of an additional capital buffer, if any, each firm would need to establish now to
withstand the potential losses in more-adverse economic conditions.
To make this assessment, we began by stipulating a hypothetical, adverse economic
scenario, under which growth, unemployment, and house-price outcomes were assumed to
be more unfavorable than those implied by the consensus of private-sector forecasters.
Using this hypothetical adverse scenario, examiners were asked to estimate the range of
possible losses that our largest and most important banking organizations could experience
over the next two to three years, as well as the resources, such as earnings and reserves,
that those organizations would have available to offset those losses. It is important to note
that this was not a solvency test. After including capital previously provided by the Treasury,
all of these banking organizations currently have capital well in excess of the minimum stated
capital requirements of the supervisors. Instead, the purpose of the exercise was to
determine the size of the capital cushion that each organization would need to remain well
capitalized and still be able to lend - even in an economic scenario more severe than
expected.
We have now learned through this process that, if the economy were to track the more
adverse scenario, additional losses at the 19 firms during 2009 and 2010 could total about
$600 billion. After taking account of potential resources to absorb those losses, including
expected revenues, reserves, and existing capital cushions, we determined that 10 of the 19
institutions will require, collectively, common or contingent common equity of $185 billion to
ensure adequate capital cushions. Of this amount, the equivalent of $110 billion has already
been raised or is contractually committed to be in place, or to a lesser degree reflects
firstquarter pre-provision earnings above those assumed in the initial supervisory estimates.
Consequently, the remaining common equity buffer that must be raised is $75 billion. The
firms that are determined to need an additional capital buffer will have 30 days to develop a
capital plan to be approved by their supervisors and six months to implement that plan. We
have strongly encouraged institutions requiring additional capital to obtain it through private
means, including, for example, new equity issues, conversions, exchange offers, or sales of
businesses or other assets. To ensure that all of these firms can build the needed capital
cushions, however, the Treasury has made a firm commitment to provide contingent
common equity, in the form of mandatory convertible preferred stock, as a bridge to obtaining
private capital in the future. Banking organizations will also have the option to exchange their
existing preferred stock, issued under Treasury's earlier Capital Purchase Program, for the
new contingent common equity. The Treasury has indicated that it expects that any such
exchange will be either accompanied or preceded by new capital raises or the conversion of
private capital securities into common equity.
Process and methodology
To properly understand the results of the capital assessment program, it is helpful to
understand the process that produced the results. All U.S.-owned bank holding companies
with year-end 2008 assets exceeding $100 billion were required to participate in the
program. These 19 firms collectively hold two-thirds of the assets and more than one-half of
the loans in the U.S. banking system, supporting a very significant portion of credit
intermediation in the United States. The assessment process can perhaps best be
characterized as a simultaneous examination of 19 large bank holding companies that
addressed all major categories of assets as well as revenue expectations.
The assessment was a resource-intensive undertaking, involving extraordinary efforts by
more than 150 examiners and analysts from the Federal Reserve, the Office of the
Comptroller of the Currency (OCC), and the FDIC. These staff members conducted a
detailed, firm-specific analysis over a 10-week period. Their efforts were aided by access to
data and management available only to bank supervisors. The supervisors also incorporated
statistical tools and quantitative models in their evaluation of each firm's data to facilitate
comparative analysis across the 19 firms.
The analysis was a comprehensive one, which included an exhaustive review of loan
portfolios, investment securities, trading positions, and off-balance sheet commitments.
Typically, supervisory examinations focus on individual business lines or asset classes at a
single firm. In this case, we simultaneously reviewed all of the major portfolios and business
lines at each of the 19 firms, making unprecedented efforts to achieve methodological
consistency across firms, portfolios, and supervisors.
Through it all, we tried to be as transparent as possible. The assumptions, processes, and
results of the capital assessment program have been communicated in detail, taking into
account legitimate supervisory and firm confidentiality concerns. We released a white paper
on April 24 describing the process and methodology.1 On May 6, we provided more
information on the measures used to size the required capital buffer, as well as a preview of
the information that would be disclosed.2 The final release of results, this past Thursday, May
7, included the supervisory-determined indicative loss rates that were used in evaluating firm
submissions, and, most importantly, aggregate and firm-specific estimates for losses, loss
rates, resources to absorb losses, and the resulting capital buffer needs.3
Finally, as I have noted, the assessment was forward-looking. To project losses and
offsetting resources two to three years in the future under the adverse scenario, we analyzed
the historical relationships of losses and earnings to macroeconomic conditions and other
determinants, and we dug deeply into cross-firm differences in portfolio compositions and
vulnerabilities.
The process began in earnest in early March when each firm submitted its estimate of losses
and earnings over a two-year scenario, under two alternative assumed paths for the U.S.
economy. The baseline scenario reflected the consensus expectation for the economy
among professional forecasters as of February 2009, and the more adverse scenario
incorporated the possibility that the recession could be more severe than the consensus
expectation and that house prices could fall even more sharply.
Although we began the process by asking the firms to submit their own estimates of
expected losses and revenues, we by no means accepted these submissions uncritically.
Senior supervisors and on-site examiners evaluated the firms' estimates to identify
methodological weaknesses, missing information, over-optimistic assumptions, and other
problems. Examiners had detailed conversations with bank managers, which led to
numerous corrections to and modifications of the firms' submissions, including sensitivity
analyses based on alternative assumptions.
As a second step, supervisors made judgmental adjustments to the firms' loss and revenue
estimates. This process used both firm-specific and comparative analyses. For example,
supervisors sometimes disagreed with the technical assumptions underlying a firm's loss
forecast. In these cases, they adjusted the loss rates based on sensitivity analyses
performed by the firm, results from other firms, and the supervisors' own expert judgments.
Third, the supervisors' judgmental assessments were supplemented by objective,
modelbased estimates for losses and revenues that could be applied on a consistent basis across
firms. For example, we used statistical models to estimate residential mortgage losses at
firms based on loan data submitted by the firms as part of the exercise. Each participating
institution was asked to supply detailed information, in a standardized format, about the
composition of its residential real estate portfolios, including breakdowns by type of product,
loan-to-value ratio, FICO score, year of origination, and so on. These data allowed
supervisors to consistently estimate potential future losses across firms using a variety of
independently constructed models. Some of these models were already in use to monitor risk
as part of the ongoing supervisory oversight process, while others were developed or refined
specifically for the capital assessment exercise.
Similarly, to assess firms' revenue projections for 2009 and 2010, the agencies examined the
components of expected revenue in detail, compared the projections to historical results, and
cross-checked the underlying assumptions with projections of portfolio growth, funding costs,
and the like. The agencies also used more-formal statistical analyses to develop firm-by-firm
forecasts that would reflect the historical relationship between revenues and macroeconomic
conditions, thereby enabling them to assess which components were less likely to be
sustainable in a weaker economy. Information from all of these sources was incorporated
into the final revenue projections. Finally, the supervisors systematically incorporated all of
these inputs into loss, revenue, and reserve estimates for each institution.
Determining the size of the capital buffer
A key question in this assessment was the appropriate size of the capital buffers that these
firms would be required to hold, as well as the quality of those buffers. Recall that our
analysis of the firms' financial conditions focused not on current capital levels alone but also
on how capital levels might evolve over a two-year horizon, assuming a more adverse
economic environment than currently anticipated. In other words, the assessment was not a
forecast of expected outcomes but rather a "what-if" exercise, intended to help supervisors
gauge the capital buffers needed to keep banks well capitalized and able to lend across a
range of economic scenarios.
In judging the needed buffer, we understood that no single measure of capital adequacy is
universally accepted or would guarantee a return of market confidence. Fortunately, our
existing capital framework is well understood and addresses the key concerns that have
been voiced by the market. Under our existing standards, banks are considered "well
capitalized" with Tier 1 capital at 6 percent of risk-weighted assets. Using that benchmark in
the context of bank holding companies, we sized the capital buffer so that each of the 19
companies would be expected to meet that threshold at year-end 2010 if the losses and
revenues implied by the adverse case were realized.
In addition, common equity ratios in various guises are viewed by stockholders, bondholders,
and counterparties as key measures of solvency, because common equity provides superior
loss absorption and greater financial flexibility than other forms of capital. Because of these
attributes of common equity, our bank holding company capital rules require that voting
common stockholders' equity make up the dominant portion of Tier 1 capital elements. In the
context of the assessment program, we have structured the required capital buffer to ensure
that, under the adverse scenario, each of the 19 firms would have a minimum 4 percent
Tier 1 Common ratio at year-end 2010. (Tier 1 Common is simply common equity subject to
the same deductions from capital as are required when determining Tier 1 capital - for
example, deducting goodwill.) Importantly, the "6-4" metric used to size the appropriate
capital buffer does not represent a new capital standard and is not expected necessarily to
be maintained on an ongoing basis. Going forward, with the required initial buffer in place,
supervisors will work with banks and bank holding companies to ensure that capital levels
are appropriate for the level of risk in banks' portfolios and in the economic environment.
Evaluating the results
Projecting credit losses in an uncertain economic environment is difficult, to say the least, but
the intensive, painstaking nature of this process gives us confidence in our results. In
particular, we believe that our estimates of needed capital buffers are appropriately
conservative. Notably, a comparison to historical loss rates shows that the loss estimates we
obtained significantly exceed those experienced in past recessions. The estimated two-year
cumulative losses on total loans under the more adverse scenario averaged 9.1 percent
across the 19 participating bank holding companies. This two-year rate is higher than any
two-year period dating back to 1920, including the historical peak loss years of the 1930s. In
particular, estimated loss rates for mortgage and consumer credit are high, reflecting the
combination of high unemployment and steep declines in house prices that were specified in
the more adverse scenario.
Still, it is useful to know whether our estimates are consistent with what has been found by
others. Two studies released within the last few weeks essentially bracketed the supervisory
estimate. The International Monetary Fund estimated lifetime losses that would imply a loan
loss rate for U.S. banking firms of about 8 percent in a stressed scenario.4 One of the major
rating agencies estimated an annual loan loss rate of about 4-3/4 percent in a stress
scenario for the next two years.5 More broadly, our informal survey of the results of a
considerable number of private-sector studies and analyst reports published over the past
several months generally placed our projected loss rates for key portfolios near the midpoints
of the ranges of these independent estimates.
When making comparisons, it should be kept in mind that studies differed in the ways that
losses were estimated and reported. Four particular sources of differences are notable.
First, studies differed in the time frames over which losses were calculated. Some outside
reports included cumulative losses from the beginning of the financial crisis in mid-2007, and
others included projections of losses over the lifetimes of currently held loans and securities.
Our estimates are for potential losses in 2009 and 2010 and, indirectly, for 2011, through the
estimate of the end-2010 loan loss reserve. Our estimates do not include the sizable losses
that have already been recognized by the 19 banks - about $325 billion of loans and
securities in the last six months of 2007 and in 2008 - because they are already reflected in
the firms' balance sheets. Moreover, while we exclude losses beyond 2011, this limit would
only be material for sizing the capital buffer if those losses were expected to substantially
exceed pre-provision earnings after 2011, an outcome that we do not expect.
Second, a few private-sector estimates implicitly or explicitly assumed mark-to-market or
liquidation prices for loans, which effectively incorporate a substantial liquidity discount in
today's market. However, because banks are portfolio lenders with core deposit funding and
the ability to hold loans to maturity, our estimated valuations are based on projected cash
flow credit losses related to a borrower's failure to meet its obligation, not a liquidation value.
Third, some private-sector studies may not have taken into account the markdowns in asset
valuations that occurred in the context of acquisitions of other firms. In particular, in the
course of acquisitions by the 19 bank holding companies in 2008, the value of troubled loans
was written down by almost $65 billion.6 These potential losses should only be realized once
and thus are excluded from our estimates of prospective losses for 2009 and 2010. Of
course, we took full account of these writedowns in our sizing of required capital buffers.
Fourth, in contrast to some outside estimates, estimated losses for the capital assessment
program are for the 19 firms, not the entire banking system. Moreover, numerous
adjustments were necessary to reflect particular facts and circumstances at these firms. That
level of analysis simply has not been done - nor could it be done - by outside observers
without the level of access available to supervisors.
Despite the care and rigor of this process, I would be the first to acknowledge that any loss
forecast is inherently uncertain. The assessment program did not address some risks that
institutions still need to consider in their own internal stress tests, such as operational,
liquidity, and reputational risks. For all 19 firms, and particularly those with trading and
investment banking businesses, those risks are important and will need to be monitored by
both the firms and the supervisors. Ideally, the stress tests used in the assessment program
should be part of a broader palette of internal stress tests conducted by firms; indeed, we do
not intend that the capital assessments should be taken as all that those firms need to do.
A principal goal of the capital assessment process is to help increase confidence in the
banking system. In particular, if it helps reduce uncertainty among investors regarding future
losses and capital needs, and thereby improves the banking system's access to private
capital, one of the key objectives of the program will have been achieved. It will be some time
before we can evaluate the success of the program on this criterion. However, the initial
indications are encouraging. Each of the 10 banks requiring an additional capital buffer has
pledged to have the necessary buffer in place by the November 9 deadline. Many of the
banks are well ahead in finding private-sector options for increasing their common equity,
and several have announced plans for new equity issues. In another positive sign, several
have announced plans to issue long-term debt not guaranteed by the FDIC.
Lessons from the assessment program for the supervisory process
We've learned important lessons in the capital assessment process that will inform our
supervisory efforts in the future. Notably, the process of comprehensively evaluating 19
major firms represented an important step forward in consolidated supervision, as it gave us
insights into the challenges posed in understanding risks and exposures across complex
organizations.
The cross-firm aspects of the assessment program were also instructive from a supervisory
point of view. As I have mentioned, unlike traditional examinations focused on individual
banks, the assessment process specifically incorporated cross-firm and aggregate analyses
of a set of firms that constitute a majority of the banking system. This approach allowed a
broader analysis of risks than is possible within the traditional supervisory focus on individual
institutions. Supervisors evaluated loss rates for similar portfolios using consistent data and
metrics, allowing them to identify outliers and more effectively evaluate the quality of
individual firm estimates. The process was an iterative one, with both the firms and
supervisors conducting sensitivity analyses around key assumptions.
The federal bank regulators - the Federal Reserve, OCC, and FDIC - cooperated
extensively throughout this process, from the design to the implementation. In addition, within
each agency, many resources across a range of skills were brought to bear. For example,
quantitative experts supported examiners by incorporating statistical tools to facilitate
benchmarking across institutions and to develop consistent loss estimates.
We learned from this effort that it is not a simple matter to simultaneously evaluate the
consolidated risks for two-thirds of the assets in the U.S. banking system, using a common
forward-looking framework and common metrics. But it was an enlightening exercise that will
improve the toolkit we use to help ensure the safety and soundness not just of individual
firms, but of the financial system more broadly.
Conclusion
In summary, the Supervisory Capital Assessment Program is an important element of
broader and ongoing efforts by the Federal Reserve, other federal bank regulators, and the
Treasury to ensure that our banking system has sufficient resources to navigate a
challenging economic downturn. A collateral benefit is that many lessons of the exercise can
be used to improve our supervisory processes. In particular, the supervisory capital
assessment has demonstrated the benefits of using cross-firm, cross-portfolio information
and the simultaneous review of a number of major firms to develop a more complete and
fine-grained view of the health of the banking system.
Whether the objectives of the assessment program were achieved will only be known over
time. We hope that in two or three years we will be able to reflect on the banking system's
return to health with a sharply diminished reliance on government capital. More immediately,
we hope and expect that the public and investors will take considerable comfort from the fact
that our largest financial institutions have been evaluated in a comprehensive and rigorous
fashion; and that they will, as a consequence, be required to have a capital buffer adequate
to weather future losses and to supply needed credit to our economy - even if the economic
downturn is more severe than is currently anticipated.