The Fed conducted its first stress test of the largest banks in 2009 to promote transparency of bank assets and reveal how much money they could lose in an adverse economy. Confidence in banks was low because portfolios were opaque, capital was scarce, and job losses were rising as the economy succumbed to the worst recession since the Great Depression.

'Turning Points'

Fed Chairman Ben S. Bernanke called the stress tests of 2009 "one of the critical turning points in the financial crisis." Speaking in April in Stone Mountain, Georgia, Bernanke said the tests "provided anxious investors with something they craved: credible information about prospective losses at banks."

The KBW Bank Index, which tracks shares of 24 large U.S. financial institutions, has risen 25 percent this year compared with a 16 percent gain for the Standard & Poor's 500 Index.

Areas where some banking companies "continue to fall short of leading practice" include not being able to show how risks were accounted for and using stress scenarios and modeling techniques that didn't account for a bank's particular risks. The Fed was critical of banks that generated projections for loss, revenue, or expenses with approaches "that were not robust, transparent, and/or repeatable, or that did not fully capture the impact of stressed conditions."

Risk Identification

The Fed criticized "capital policies that did not clearly articulate" a banking company's goals and targets and "did not provide analytical support for how these goals and targets were determined to be appropriate." It also found examples of "less-than-robust governance or controls around the capital planning process, including around fundamental risk-identification."

Banks this year also were required to submit their own stress test to the Fed, which supervisors reviewed to ensure the institutions understood their particular risks and vulnerabilities.

"The range of observed practice for developing" bank holding company "stress scenarios was broad," the report said.

Banks with credible stress tests demonstrated a clear link between an adverse event and the company's outlook. Banks with less-credible tests weren't as clear about how their regional or industry concentrations were linked to "relevant geographic or industry variables," the report said.

'Enormous Strides'

Banks have "made the most enormous strides—it just shows how much further the regulator wants them to go," Christopher Wheeler, an analyst at Mediobanca SpA in London, said today in a phone interview. "This takes time, it doesn't happen overnight, given how much has been going on in the markets and how much the laws have changed."

A common thread throughout the report is the importance of information systems to decision making. Banks that had strong information systems in place "enabled them to collect, synthesize, analyze, and deliver information quickly and efficiently," the report said. Still, "many" banking companies "have systems that are antiquated and/or siloed and not fully compatible, requiring substantial human intervention to reconcile across systems."

The Fed was also critical of favorable assumptions applied to assets and liabilities in a financial crisis. Examples of "aggressive" assumptions include "large changes in asset mix that serve to decrease" risk weights and improve post-stress capital ratios, a beneficial inflow of low-cost deposits, and "significant balance sheet shrinkage" with no consideration of the kinds of losses the bank would experience selling those assets in a period of market stress.

The Fed conducts two types of tests. One, under the Dodd-Frank Act, takes a standardized look at how bank portfolios and capital might fare in an economic calamity, holding dividends constant with no stock repurchases. The second test—the Comprehensive Capital Analysis and Review—assesses bank planning to see if boards can adequately guide the use of capital through turbulent conditions, trimming stock buybacks and dividends if necessary.

Both Fed regulators and bank boards neglected to enforce capital conservation at the start of the financial crisis. The 19 largest banks in 2007 paid out more than $43 billion in dividends as housing prices continued to fall, and an additional $39 billion in 2008 as the crisis began to accelerate, Patrick Parkinson, the former head of the Fed Board's supervision and regulation division, said in 2011.

While shareholders gained, taxpayers had to subsequently shore up the banking system. The Treasury used the Capital Purchase Program to buy $204.9 billion in preferred stock in 707 financial institutions, according to government records.

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