Federal Reserve Governor Daniel Tarullo defended the importance of stress tests and capital plans in ensuring the safety and soundness of the U.S. financial system.
In a speech to the Federal Reserve Bank of Chicago Annual Risk Conference Tarullo said that higher capital standards alone were not enough to do the trick. He said the added capital must be viewed through the lens of these two supervisory tools. This way regulators, banks and their counterparties have a better idea of which institution is best able to sustain itself during times of financial stress.
Tarullo gave four reasons why raising capital levels alone was not enough to protect the system from a crisis: Capital ratios often lag as an indicator of a bank’s health. In a crisis it’s not just asset values that get hurt, but also revenue generating ability. Regular capital requirements don’t cover shocks to the system. Finally, regular communication between banks and their regulators is needed to understand banks’ capital positions.
Tarullo defends regular stress testing as well as regulatory review of banks’ capital plans to help shore up the financial system’s defenses. He says that the 2012 stress test showed banks had made progress on their capital positions, but that there was room for improvement at all 19 banks tested. Some, he added, needed “significant work” on their capital bases. Stress tests are a necessity for banks with $50 billion or more in assets, but banks with less than $10 billion of assets don’t need supervisory stress testing, according to Tarullo.
While the Fed is mindful of criticism of its loss modeling in the 2012 stress tests, Tarullo said the Fed will focus on improving its communication with banks in future tests.
One important note for banks, as of 2013, the Fed will make its decisions on capital actions at the start of the second quarter, after the results of the annual stress test. That is a more relaxed timetable than the 2012 stress tests.
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