US regulators told to expand stress-test programme

The US Treasury should expand its bank holding company stress-testing programme to include smaller firms, the Congressional Oversight Panel said on August 11.

WASHINGTON, DC - Regulators conducted stress tests on the 19 largest US banks in May under the Supervisory Capital Assessment Program, which resulted in 10 banks having to raise a combined $74.6 billion in additional capital.

However, in its August report, The continued risk of troubled assets, the panel concluded that testing only the 19 largest bank holding companies was not enough, claiming smaller banks are more at risk from troubled assets.

"The stabilisation of the financial system is a significant achievement, but it does not mark an end to the crisis. It would be foolish to think that the risk of troubled assets has been mitigated or that it does not remain the most serious risk to the US financial system," the report said.

The panel said the bulk of problem assets held on bank balance sheets were residential real estate loans, particularly whole loans, rather than complex securities. And while sentiment towards financial institutions has improved in recent months, if tightening credit default swap spreads are an accurate indicator, problems in the residential housing market remain.

According to figures from RealtyTrac, a Californian online real estate company specialising in foreclosure properties, foreclosure filings were reported on 360,149 properties in July, a 7% increase from June and a 32% increase from July 2008.

However, the panel fears commercial real estate loans could pose the greatest danger in future, suggesting they have a riskier profile and the potential for higher defaults. New York-based property research firm Real Estate Econometrics reported that in the first quarter the national default rate for commercial real estate mortgages held by regulated depository institutions rose to 2.25% -its highest level for 15 years.

Justifying its call to extend the stress-testing programme, the panel said small banks hold greater concentrations of commercial real estate loans than the institutions currently stress tested. It suggested sample testing, rules for self-testing or general templates could provide an approximation and might lead to a general formula for determining whether additional capital is required.

It recommended stress tests on the 19 bank holding companies be repeated if economic conditions prove more severe than the scenarios used in the May tests. Even assuming conditions ease, the panel insisted the 19 banks should regularly conduct stress tests based on macro scenarios, such as those used by regulators.

The panel also expressed concern at the failure to start the proposed legacy loans programme (LLP), part of the Public-Private Investment Program (PPIP), designed by the Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation to reopen the market for troubled loans. Although the PPIP launched a scaled-down legacy securities programme at the start of August, the LLP remains on the backburner.

The panel suggested an alternative might be to establish an equivalent to the Resolution Trust Corporation, set up in 1989 to liquidate the assets of insolvent savings and loan associations.

In addition, the report demanded greater transparency and accountability from regulators and banks about the scope of the troubled asset problem. The panel suggested supervisors review the way banks model the risk on the assets they hold, as part of their balance sheet and reporting requirements.

The report stated: "The problem of troubled assets was long in the making and it would be foolish to think it could be resolved overnight, or that doing so would not involve balancing equally legitimate considerations affecting the banking industry and the public interest."