[ForexNews]

Bernanke explains stress tests and concludes on an optimistic note; also comments on dollar's reserve status and FOMC inflation preference (around 2%)

In a speech yesterday Fed Chairman Bernanke provided a concise overview of the bank stress tests. The tests were designed to provide a forward-looking assessment of prospective losses at the 19 largest US banks, which collectively hold two-thirds of the assets and more than one-half of the loans in the U.S. banking system. The tests measured how much additional capital buffer each bank would need under a more adverse economic outcome.

There were three steps to the bank tests. First, each bank submitted forecasts for losses and revenues under different economic scenarios. The regulators, which included analysts from the Federal Reserve, OCC and FDIC, modified the firm's projections after discussions with the banks. Second, the regulators used sensitivity analysis to adjust the loss rates as they deemed appropriate. Third, the regulators ran models to estimate losses, allowing for more objective examination. In order to estimate capital buffers, the regulators applied a "6-4" metric which calls for Tier 1 capital at 6 percent of risk-weighted assets and a minimum 4 percent Tier 1 Common ratio at year-end 2010. The results, as already released, showed that additional losses could total $600bn in a more adverse scenario. This would require the banks to raise another $75bn for a common equity buffer.

While Mr Bernanke noted the uncertainty with the results, he argued that the tests serve an important purpose of reducing uncertainty among investors and boosting confidence in the banking system. Indeed, in his view, the initial results are encouraging as each bank has been able to find private-sector options to raise capital. Looking ahead, the framework of the Supervisory Capital Assessment Program would "improve the toolkit we use to help ensure the safety and soundness not just of individual firms, but of the financial system more broadly."

Mr Bernanke concluded on an optimistic note, stating that as a result of the stress tests banks will have a "capital buffer adequate to weather future losses and to supply needed credit to our economy--even if the economic downturn is more severe than is currently anticipated.

In Q&A Mr Bernanke was asked to comment on PBoC Governor Zhou's suggestion that the dollar might be replaced by the SDR as a reserve currency: he responded by saying that he thought Mr Zhou's comment was in a "long-term" and "hypothetical" vein, adding, "I think the issue at hand is whether or not the dollar will retain its value, and I think it will". He also noted that the majority of FOMC had signalled, through their long term inflation projections, that inflation needed to be around 2%. He also noted that the FOMC had been working on its "exit strategy" quite intensively, and had "four or five tools" it could use to shrink its balance sheet and to tighten monetary policy.