Fed’s Tarullo: Consider routine bank stress tests

By Emily Kaiser

WASHINGTON (BestGrowthStock) – Regulators should consider conducting routine, publicly disclosed “stress tests” to gauge how well big financial firms could weather a crisis, a top U.S. Federal Reserve official said on Tuesday.

Fed Governor Daniel Tarullo, the central bank’s point person on regulatory reform, said releasing the information would help investors make informed decisions, and encourage public scrutiny of the regulators’ methods.

The Fed led stress-testing of the 19 largest U.S. financial firms last year and disclosed the results, a controversial decision even inside the central bank. The concern was that weaker banks might be harmed by the public disclosure.

“But I think that regularizing both stress tests and the release of information relevant to them deserves serious consideration,” Tarullo said in a speech to the Council of Institutional Investors.

Tarullo acknowledged that there may be times when releasing the information could be “unnecessarily destabilizing,” particularly if the results showed banks needing capital in more normal times when the government is not providing emergency capital injections as it was last year.

“Major unpleasant surprises would be less likely with frequent, detailed disclosures,” he said.

Tarullo, whose speeches are closely watched for insight into the Fed’s thinking on regulatory reform, argued that regulators should be open to greater outside scrutiny and discussion, “including dissident voices.”

The Fed has been criticized for being too secretive, particularly about firms that borrow from its emergency lending facilities. While Tarullo did not suggest the central bank lift the veil on those operations, he said it would help supervisors do their job better if officials were required to confront and respond to critiques directly.

‘YOU WILL SUFFER LOSSES’

On what to do about big, interconnected firms whose failure could destabilize the financial system, Tarullo said both shareholders and creditors should expect to bear losses.

Creditors were largely spared when Bear Stearns was on the brink of collapse in early 2008, and that pattern was repeated in other government bailouts.

Tarullo did not mince words with a room full of investors: “To personalize things for this audience, we must ensure that if you have invested money in a large financial firm that runs aground, you will suffer losses,” he said.

He also raised some concerns about requiring that large financial firms hold “contingent capital,” which essentially looks like debt in normal times but converts to equity during financial turmoil.

Specifying what would trigger the conversion is critical, Tarullo said. If supervisors hold that power, investors cannot be certain when it would be exercised.

Opting for a market-based mechanism was also problematic because it could encourage manipulation if traders intentionally tried to trigger it. Tarullo said in extreme cases that “could lead to a so-called death spiral for the firm’s stock.”

“Despite the work that has been done on contingent proposals, it is not yet clear if there is a viable form of contingent capital that would increase market discipline and provide additional capital in times of stress without raising the price of the convertible debt close to common equity levels,” Tarullo said.

Stock Research Tools

(Additional reporting by Rachelle Younglai; Editing by Patrick Graham)

Fed’s Tarullo: Consider routine bank stress tests