Inside Financial Services

Stress Tests for Regional Banks? Unbelievable—and Idiotic

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The early results are in regarding the stress tests results submitted by regional banks, and they are . . . preposterous.

Did you know that regional banks—in this case, banks with between $10 billion and $50 billion in assets–are even subject to regulatory stress tests? Well, they are–but why, I can’t say. (More on this in a moment.) Anyway, here are the government’s mandated assumptions behind this particular doomsday exercise:

  • The unemployment rate jumps to 10.1%;
  • Real GDP drops by 6.1%;
  • The Dow Jones Industrial falls to 8,600 by the end of this year;
  • Lots of other ghoulish assumptions.

I’ll get to the results in a moment, but first, who comes up with these numbers? Who at the Fed (or wherever), for instance, decided that, under the “severely adverse” scenario the government has in mind, the unemployment rate would rise to ten point one percent? Not 10%. Not 10.5%. Ten point one. I understand that in imagining a hypothetical unpleasant situation, one has to make certain assumptions, but the level of specificity assumed in this particular hypothetical situation is a little hard to take seriously. A more cynical observer might even wonder whether the test was designed to be gamed.

The most important bottom-line result of a stress test is of course what happens to a given bank’s Tier 1 capital ratio. If the ratio falls below 5%, regulators say, that would be a problem. So how did the early reporting banks do? Here are some of the results:

  • At First Republic Bank, Tier 1 capital would supposedly fall to 9.9% at the end of 2016, from 11.1% in the third quarter of 2014.
  • Associated Banc-Corp, Tier 1 capital would fall to 9%, from 10.3%.
  • First Horizon, Tier 1 would go to 10% from 11.4%.
  • At First Niagara Financial, to 8.04% from 8.19%. (Just a 15-basis-point decline? Seriously?)

So we’re supposed to believe, if we’re asked to take these stress test results seriously, that in the event of an economic collapse comparable to the one that happened in 2008 and 2009—wherein the stock market would be cut in half, for instance—the balance sheets of midsized banks would be largely unscathed. Sorry, I’m not buying that. What’s more, I’m at a loss to understand why regional banks even had to go through this ridiculous exercise in the first place. During severe financial downturns like the “severely adverse” one the feds have in mind, it’s not capital that people will be worried about. No matter what your stress-test model says beforehand, during a panic, a given bank’s capital will be assumed to be worth essentially zero. Rather, liquidity will be the issue—just as it was in 2008 when liquidity providers were so addled about even the Goldman Sachses and Morgan Stanleys of the world that the two had to get bank charters (and thus direct access to the Treasury) to avoid insolvency. Their capital levels were totally beside the point.

And more broadly, what is the point of subjecting regional banks to stress tests, anyway? The big banks need to undergo them, the rationale goes, because they are “systemically important” and so would put the entire financial system at risk should the run into severe financial trouble. But the regional banks aren’t systemically important. They’re regional banks. If one of them fails—as happens more or less regularly, by the way—not a single additional systemic domino would fall. Rather, the FDIC would swoop in, keep depositors whole, and divvy up whatever is left over in a manner that minimizes taxpayer losses. The notion that these institutions are subject to systemic regulation is ludicrous.

The new overregulation of the banking system never ceases to provide opportunities for amazement. Here we have yet another example.

What do you think? Let me know!

3 Responses to “Stress Tests for Regional Banks? Unbelievable—and Idiotic”

  1. S

    And it doesn’t stop there! I work at a bank FAR below the $10 billion level with good capital, strong liquidity, strong profitability, strong reserves and pretty good asset quality. We have now been asked to do the same type of stress testing, and unfortunately given the power the regulators hold to make life miserable for even a strong bank, “asking” is essentially a direct order.

    And yes, the specificity of the input metrics is laughable and the output of the tests is too.

    • william

      Dick Bove said it this week,,,,,banks are nationalized. no doubt about it.

  2. SWPilgrim

    Next, a”living will” wherein they sell themselves to TBTF competitors!SWP

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