Determining the Size of the Capital Buffer
In judging the needed buffer, we understood that no single measure of capital adequacy is universally accepted or would guarantee a return of market confidence. Fortunately, our existing capital framework is well understood and addresses the key concerns that have been voiced by the market. Under our existing standards, banks are considered “well capitalized” with Tier 1 capital at 6 percent of risk-weighted assets. Using that benchmark in the context of bank holding companies, we sized the capital buffer so that each of the 19 companies would be expected to meet that threshold at year-end 2010 if the losses and revenues implied by the adverse case were realized.
In addition, common equity ratios in various guises are viewed by stockholders, bondholders, and counterparties as key measures of solvency, because common equity provides superior loss absorption and greater financial flexibility than other forms of capital. Because of these attributes of common equity, our bank holding company capital rules require that voting common stockholders’ equity make up the dominant portion of Tier 1 capital elements. In the context of the assessment program, we have structured the required capital buffer to ensure that, under the adverse scenario, each of the 19 firms would have a minimum 4 percent Tier 1 Common ratio at year-end 2010. (Tier 1 Common is simply common equity subject to the same deductions from capital as are required when determining Tier 1 capital–for example, deducting goodwill.) Importantly, the “6-4″ metric used to size the appropriate capital buffer does not represent a new capital standard and is not expected necessarily to be maintained on an ongoing basis. Going forward, with the required initial buffer in place, supervisors will work with banks and bank holding companies to ensure that capital levels are appropriate for the level of risk in banks’ portfolios and in the economic environment.
Evaluating the Results
Projecting credit losses in an uncertain economic environment is difficult, to say the least, but the intensive, painstaking nature of this process gives us confidence in our results. In particular, we believe that our estimates of needed capital buffers are appropriately conservative. Notably, a comparison to historical loss rates shows that the loss estimates we obtained significantly exceed those experienced in past recessions. The estimated two-year cumulative losses on total loans under the more adverse scenario averaged 9.1 percent across the 19 participating bank holding companies. This two-year rate is higher than any two-year period dating back to 1920, including the historical peak loss years of the 1930s. In particular, estimated loss rates for mortgage and consumer credit are high, reflecting the combination of high unemployment and steep declines in house prices that were specified in the more adverse scenario.
Still, it is useful to know whether our estimates are consistent with what has been found by others. Two studies released within the last few weeks essentially bracketed the supervisory estimate. The International Monetary Fund estimated lifetime losses that would imply a loan loss rate for U.S. banking firms of about 8 percent in a stressed scenario. One of the major rating agencies estimated an annual loan loss rate of about 4-3/4 percent in a stress scenario for the next two years.5 More broadly, our informal survey of the results of a considerable number of private-sector studies and analyst reports published over the past several months generally placed our projected loss rates for key portfolios near the midpoints of the ranges of these independent estimates.
When making comparisons, it should be kept in mind that studies differed in the ways that losses were estimated and reported. Four particular sources of differences are notable.
First, studies differed in the time frames over which losses were calculated. Some outside reports included cumulative losses from the beginning of the financial crisis in mid-2007, and others included projections of losses over the lifetimes of currently held loans and securities. Our estimates are for potential losses in 2009 and 2010 and, indirectly, for 2011, through the estimate of the end-2010 loan loss reserve. Our estimates do not include the sizable losses that have already been recognized by the 19 banks–about $325 billion of loans and securities in the last six months of 2007 and in 2008–because they are already reflected in the firms’ balance sheets. Moreover, while we exclude losses beyond 2011, this limit would only be material for sizing the capital buffer if those losses were expected to substantially exceed pre-provision earnings after 2011, an outcome that we do not expect.
Second, a few private-sector estimates implicitly or explicitly assumed mark-to-market or liquidation prices for loans, which effectively incorporate a substantial liquidity discount in today’s market. However, because banks are portfolio lenders with core deposit funding and the ability to hold loans to maturity, our estimated valuations are based on projected cash flow credit losses related to a borrower’s failure to meet its obligation, not a liquidation value.
Third, some private-sector studies may not have taken into account the markdowns in asset valuations that occurred in the context of acquisitions of other firms. In particular, in the course of acquisitions by the 19 bank holding companies in 2008, the value of troubled loans was written down by almost $65 billion.6 These potential losses should only be realized once and thus are excluded from our estimates of prospective losses for 2009 and 2010. Of course, we took full account of these writedowns in our sizing of required capital buffers.
Fourth, in contrast to some outside estimates, estimated losses for the capital assessment program are for the 19 firms, not the entire banking system. Moreover, numerous adjustments were necessary to reflect particular facts and circumstances at these firms. That level of analysis simply has not been done–nor could it be done–by outside observers without the level of access available to supervisors.