WASHINGTON, Oct 17 (Reuters) - Banks' reliance on poor risk models is among the problems the Federal Reserve found in its health check of the largest U.S. financial institutions, as the Fed explained for the first time on Friday what it thinks of this year's industry submissions.
The Fed's list of flaws that come with banks' disclosures for the so-called stress test show that while progress has been made, the two sides are still a ways off in their expectations.
"(Banks) should not rely on weak or poorly specified models," the Fed said in a set of instructions for the next round of the tests, which will take place in 2015.
Banks made assumptions that weren't always well documented or supported, did only cursory validation checks in some cases, and made assumptions without knowing if they were doable, the Fed said in its statement.
The annual exam on the 30 largest financial institutions operating in the U.S. is seen as a critical part of the government's ability to ensure that individual banks are prepared to withstand the next financial crisis.
Failure to pass can come with major consequences.
The Fed this year rejected Citigroup's capital plan, a key part of the stress test, which meant the U.S. bank was prohibited from proceeding with a $6.4 billion share buyback and a dividend boost. Bank of America had to redo its capital plan after errors in calculating capital ratios.
Global regulators reporting to the Financial Stability Board, a group of regulators of the G20 economies, highlighted poor data quality as a major concern in January, telling countries improving should be a top priority.
Fed Governor Daniel Tarullo has condemned the latitude that international capital rules known as Basel III give banks to use their own models, and wants to rely more on the stress tests, the Fed's own yardstick of bank health.
"One of the most common issues across firms is unclear or unsubstantiated assumptions," the Fed said. "Loan and deposit pricing assumptions were, in many instances, not well documented nor adequately supported."
It was the first time the Fed made public its concerns with this year's stress tests, which were introduced after the 2007-09 crisis to reduce the risk that taxpayers would again have to spend billions to bail out Wall Street.
Any U.S. bank, or unit of an overseas bank, with total assets of more than $50 billion on its books automatically has to take part in the exercise, in which 30 banks participated last year. This year, a unit of Deutsche Bank would join the group for the first time, the Fed said. (Reporting by Douwe Miedema; Editing by Chizu Nomiyama)