U.S. Regulator Criticizes Banks On Risk Models

U.S. Federal Reserve criticized how some of the 19 largest U.S. banks calculated potential losses and planned dividends in this year’s stress tests, people with knowledge of the process said.

The critiques will be part of feedback letters sent to the lenders this week that cover everything from data collection to risk measurement. Flaws included marking down all housing prices at the same rate, rather than matching them to specific regions, and planning dividends that could drain needed capital.

“A 20 percent decline in national house prices would mean that prices would decline substantially more in some markets and less in others,” Daniel Tarullo, the Fed governor in charge of supervision, told a Chicago banking conference on April 10. “The result would be higher overall losses than if prices had declined by a uniform 20 percent everywhere.”

The letters arrive as tensions mount between the largest banks and the Fed over how new rules to make the financial system safer will be carried out. Bankers have complained the stress tests completed in March lack transparency and underestimate their underwriting abilities, resulting in higher losses on some asset classes than the lenders projected.

“We strongly urge the Federal Reserve to provide detailed explanations of methodologies, models, techniques and underlying assumptions,” five banking trade groups led by the Clearing House Association said in an April 27 letter to the Fed. “It is simply unfair to ask a bank to pass a test — and manage toward the standards of that test — if the parameters are largely unknown.”

The Fed critiques are the most detailed feedback the banks have received on their 2012 stress-test submissions. Among the models singled out for criticism are those that showed progressive instead of abrupt leaps in credit losses in the stress scenario as unemployment rose and the economy shrank.

The central bank developed the stress tests during the depths of the financial crisis as Chairman Ben S. Bernanke sought to gauge the strength of the banking system, and lawmakers have made them an annual requirement for the biggest lenders. Regulators have said they want banks to manage their capital to limit the risk of future taxpayer bailouts.

The Fed probably will push back when banks’ dividend payout plans exceed what’s feasible under the companies’ own projected losses as it may indicate a break in communication between risk managers and boards.

“Significant deficiencies in the capital-planning process” may result in a bank failing the test, Tarullo said last month, according to Bloomberg.