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Analysis: US banks under stress

Ten of America’s 19 largest financial institutions might be required to raise a total of $74.6 billion (£49.5 billion) in capital, according to the official American “stress tests”.

The institutions had to undergo the stress tests, officially known as the Supervisory Capital Assessment Program (SCAP), so that regulators could determine whether capital buffers were sufficient enough to withstand losses and sustain lending. It embodied assumptions about variables such as likely GDP growth and unemployment levels.

American Express, BB&T, Bank of New York Mellon, CapOne, Goldman Sachs, JP Morgan Chase, MetLife, State Street and UBS “passed” the tests.

But Paul Ashworth, a senior US economist at Capital Economics, says the estimated losses under the scenario used “still look too low”.

Although the report highlights that the estimates are based on “a scenario that is more adverse than expected”, Ashworth says that the macroeconomic scenarios used in the stress tests “do not appear to be extreme enough”.

Ashworth adds that it is too soon to declare that American banks are even close to being adequately capitalised to cope with the losses they still face and be in a position to increase lending comfortably again.

However, Ben Bernanke, the chairman of the Federal Reserve, said the results should provide “considerable comfort to investors and the public”.

“The examiners found that nearly all the banks that were evaluated have enough tier one capital to absorb the higher losses envisioned under the hypothetical adverse scenario,” he says in a statement on the Fed’s website.

“Roughly half the firms, though, need to enhance their capital structure to put greater emphasis on common equity, which provides institutions the best protection during periods of stress. Many of the institutions have already taken actions to bolster their capital buffers and are well-positioned to raise capital from private sources over the next six months.”

The stress test estimates that if the economy were to track the more adverse scenario, those 19 firms could lose a combined $600 billion between 2009 and 2010.

According to the report published on the Fed’s website, the bulk of the estimated losses – about $455 billion – come from losses on the bank holding companies’ (BHCs) accrual loan portfolios: in particular, from residential mortgages and other consumer‐related loans.

“After taking account of losses, revenues and reserve build requirements, in the aggregate, these firms need to add $185 billion to capital buffers to reach the target SCAP capital buffer at the end of 2010 under the more adverse scenario.”

The $185 billion relates to 10 firms, as the rest already have “capital buffers sufficient to get through the adverse scenario”.

The report says two‐year cumulative losses on total loans could be 9.1% at the 19 participating BHCs. And this estimated rate is higher than during the “historical peak loss years” of the 1930s. Possible losses from trading‐related exposures and securities held in investment portfolios could total $135 billion.

In combination with the losses already recognised since mid‐2007, the stress test results suggest, financial crisis‐related losses could total nearly $950 billion by the end of next year, provided that the economy follows the more adverse scenario.

At the end of 2008, the report continues, capital ratios at these 19 firms exceeded the minimum regulatory capital standard tier one capital at these firms totaled about $835 billion. Most of them also met supervisory expectations on the composition of capital.

“The practical implication of this capital is that many of the BHCs already had substantial capital buffers in place to absorb their share of the estimated $60 billion of losses.” Banks will realise revenues from ongoing businesses to absorb losses, the report says, though at a lower level in the weak economic conditions of the stress scenario than in the baseline. Some of those revenues will need to go into building loan loss reserves against credit problems in 2011.

Ashworth says that although regulators may be happy enough to allow capital to fall sharply, such a deterioration would cause bank stocks to plummet again.

Bernanke said the government was ready to provide “whatever additional capital may be necessary to ensure that our banking system is able to navigate a challenging economic downturn.”

The stress test was conducted by the three independent federal banking supervisory agencies: the Fed, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation.

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