Banks and Fed's Stress Test Models Far Apart
The Federal Reserve's most recent stress test shows all but one of the nation's 18 largest banks are prepared to handle a severe economic shock. That is an improvement from last year when two banks failed to meet the minimum requirements outlined by the central bank.
What has not yet improved, is the gap that exists between the big banks' and the Fed's models for such an event. Looking at the banks' results of how they fared under the Fed's "severely adverse scenario" using their internal models, suggests the banks' models are less stringent than the Fed's.
(Read More: Stress Tests 'Just Not Very Stressful' for Banks)
For example, Morgan Stanley met all the minimum requirements for the four metrics the Fed used to test the bank's health in an economic downturn that included, among other things, an unemployment rate of 12 percent, a 50 percent decline in stock prices and 20 percent decline in housing prices. But Morgan Stanley's own model painted a much better picture of the firm's capital ratios, applying the same economic data.
Under the Fed's model, Morgan Stanley's Tier 1 Common ratio—measures a bank's ability to withstand losses—in a severely stressed environment fell to a low of 5.7 percent. Under the bank's model, it fell to 6.7 percent. It was the same thing with Morgan's Tier 1 Capital ratio—a broader way to access whether a bank can survive losses—the Fed's model showed it at 7.5 percent in a worst-case scenario, while the bank's model put it a full percentage point higher at a more robust 8.5 percent.
(Read More: Citi Bests Stress Tests, Discloses Buyback Plan)
The difference was even greater at Goldman Sachs. Under the bank's model Tier 1 common drops to a relatively healthy 8.6 percent at the bottom of the adverse scenario, the Fed's models put its well below that level at 5.8 percent.
Ally Financial, the only bank whose Tier 1 common ratio fell below the 5 percent minimum required by the Fed, said in a statement that it believed the Fed's stress test was "fundamentally flawed" and that the analysis was not consistent with what the firm had experienced in the most stressed periods of the business.
Majority-owned by the government following a bailout, Ally's Tier 1 common took a hit because of its exposure to subprime mortgages.
Goldman Sachs did not return calls seeking comment and Morgan Stanley declined comment about the difference in the models. It would be difficult to comment, anyway given the banks do not know the Fed's model. There have been complaints in the past that the Fed is not clear about what it expects from the banks in modeling for the stress tests. The Fed has said repeatedly the process needs fine tuning. Given the differences in opinion, it looks like the banks will be asking for more guidance from the Fed in the future.
—By CNBC's Mary Thompson; Follow her on Twitter: