Inside Financial Services

More Stress-Test Nuttiness

There's a more sensible tool to make sure banks are strong enough. The feds have been using it for years.

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I was on Bloomberg TV this morning and the host, Betty Liu, wanted to know what I think about this new round of stress tests the government has in store for the banks. I told her that they’re a really dumb idea. But TV news being the fast-paced enterprise it is, I didn’t have an opportunity to engage in an extended rant as to why.

So allow me to elaborate now. These annual stress tests for the banks are an incredibly stupid, truly nonsensical practice. They are the sort of crazy scheme that Congress sometimes hatches which makes so many of us wonder whether the people we send to Wasghington really are idiots.

Go back to banking basics, and I’ll explain what I mean. The reason banks carry capital on their balance sheets in the first place, over and above the loss reserves they book when they write loans, is so they can navigate through and survive periods of unexpected losses. One might even think of those periods of unexpected “stress.” Related to that, banking regulators specify the minimum amount of capital that banks must carry to see them through such periods of . . . um . . . stress. If regulators don’t think the minimum standards they’ve set are sufficient for banks to see them through those times of . . . stress . . . they can and should raise the standards. The whole point of minimum capital standards, after all, is to ensure that banks survive unexpected periods of stress.

You see where I’m headed with this, don’t you? If the country’s banking regulators don’t believe that the minimum capital standards they themselves have promulgated aren’t sufficient to get the banking industry through a storm, they should raise the darn standards! It’s easy! No act of Congress needed. No environmental review. Just send a memo out to the banks and tell ‘em that to be considered “well-capitalized” they now need to maintain a Tier 1 ratio of 10%, or 12%, or whatever-just pick a number!

But if these same regulators are required (which they are, by this marvelous Dodd-Frank Act) to run annual stress tests on the banks to ensure that banks’ finances really are strong enough to get banks through tough times, then their own minimum capital standards are meaningless. How can that make sense? It doesn’t-but the regulators don’t care. They love the new stress tests since the tests will help them cover their own keisters when things go bad.

If the government believes the world has changed, and that future credit downturns are apt to be more severe than past ones, that would be totally rational. Even prudent. But the response should not be to layer in a new round of annual stress tests for the banks, it’s to dial up the minimum amount of capital cushion that banks have to hold. Duh. This shouldn’t be complicated. Even for the people who work in government.

What do you think? Let me know!

11 Responses to “More Stress-Test Nuttiness”

  1. Anonymous

    Keeping it simple is usually the best plan. Unfortunately you are totally missing the point that the mega banks are all very complex with substantial capital markets risk. The stress tests at least attempt to uncover market related risks that historically have not been contemplated by reg capital ratios.
    Also why should your favorite bank SNV be subject to the same capital requirement as JPM when the risk profiles are totally different?

  2. Tony Abbate

    Instead of conducting stress tests, the government should make these banks write down the loans on their balance sheets to fair market value. This would be much more valuable than stress tests. I think banks as a whole are destined to be zombies for the next 5 to 10 years. Avoid them – especially when there are so many other areas in financials like asset managers and select insurers that are easier to understand.

  3. Brian H

    The stress tests are all about the assumptions which are nothing more than….forecasts. The issue is that no sane human being would expect a regulator to have above average forecasting ability.

  4. linques

    I think it is an admisson by the regulators that they don’t know how the non-traditional products/business lines of the mega-banks will react under stress. Certainly isn’t perfect but the “Volker rule” is still the best response I’ve seen.

  5. linques

    I think it is an admisson by the regulators that they don’t know how the non-traditional products/business lines of the mega-banks will react under stress. Certainly isn’t perfect but the “Volker rule” is still the best response I’ve seen.

  6. Ken Greenberg

    A good Thanksgiving chuckle. What should we expect, after all, from the group that thinks a $15,000,000,000,000 national debt is ok? Who can’t even find $1.2 trillion in cuts… OVER TEN YEARS. The only thing they’re giving the banks and us is… STRESS.

    Happy Turkey!

  7. Ole R. Holsti

    Idiots in Washington look like geniuses compared to the idiots that run banks. Ken Lewis ran BAC into the ground but payed himself two $25 million bonuses for taking over Merrill Lynch and Countrywide. Ken Thompson ran Wachovia into the ground with his takeovers of Golden West, etc. How stupid can one be.
    Then there is the [unnamed] idiot who flogged an [unnamed] savings bank on these pages only to see the stock and earnings plunge over 75%.
    Ole R. Holsti

  8. Ed O'Leary

    There is a more benign possibility than rank stupidity. Since the FRB will be releasing the results from last year there will be more transparancy than we had before. If these forthcoming ones are released after shorter intervals, we’ll know quite a bit more than before. Generally though, you don’t ask the question until you’re pretty comfortable that you’re going to like the answer.

  9. BankerGirl

    I cannot agree with you on this one …. Capital Adequacy requirements are based on unexpected losses through the “normal” economic cycles … stressing the capital adequacy based on unexpected but, catastrophic shocks – e.g., effect of the earthquake/tsunmi in Japan – is totally valid (in my opinion). On the other hand, stress testing should not be used to replace prudent lending and valuation practices or appropriate governance which is what seems to be the case. Your suggestion to arbitrarily ratchet up the minimum capital ratios is punitive to the well managed F.I.s and is not the way to inspire confidence that the financial system is sound.

  10. JRG

    How can you argue with greater transpareny and more sophisticated analysis of a banks capital requirments in difficult times. As pointed out above different banks have different risk profiles and thus wil have different capital requirements. The banks are doing the analysis not the Fed. The Fed is doing the right thing here pushing for higher capital requirements for the top banks- making them less risky and reducing risk to the financial system. These banks are to big, to complex and impossibel to mange effectively. If they cant be broken up legislatively they should be forced to reduce their risk profile and threat to the economy with significantly increased capital requirements and regulation.

  11. JLC

    Have to agree with Brian H on this one. The assumptions around the modeling is what is important. Agree that our astute regulators could just flip a switch and raise the capital standards. You have to be able to accurately forecast a particular stress environment to determine if you have sufficient capital. That’s exactly why we are in the mess we are today. Nobody was able to accurately step back and say if this particular environment unfolds, how is it going to play out though specific banks and the economy as a whole. At the end of the day, you can’t possibly model every possible economic outcome. You need to have a strong financially disciplined management approach. Of course, this assumes that our duly elected officials and in turn, regulatory bodies come back around to the idea that it’s OK if banks generate a profit!!!

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