Inside Financial Services

Those Distressing Stress Tests

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How does the Fed think its crazy, tight-lipped approach to conducting its stress tests is supposed to strengthen the banks? It’s not. All it’s doing is confusing the banks. What good that is is beyond me. This whole process is preposterous.

The stress tests, recall, are required annually by Dodd-Frank and are supposed to provide a sense of how the finances of the largest banking institutions would hold up under a severely negative economic scenario. The Fed comes up with some ugly assumptions regarding things like unemployment, home values, stock prices, and GDP growth, and then it and the individual banks estimate where key measures such as capital ratios and net income would come out under those conditions.

You may or may not believe this is a worthwhile exercise in the first place (it’s not), but the Fed has carried it all out in such an opaque way that the stress tests have confused as much as they have clarified. Reason: the Fed’s own test results are in many cases at extreme odds with the banks’ own conclusions, and yet the Fed won’t expalin why. The Wall Street Journal reports, for instance, that JPMorgan Chase concluded that under the stress scenario specified by the Fed, its Tier 1 capital would come to 8.0%. But the Fed itself, looking at the exact same assumption, came up with a Tier 1 ratio of just 5.4%. Which is more realistic? But since the Fed won’t specifically explain where it differs from the banks, the banks are left in the dark.

This is no way to regulate a banking system. If the Fed has a particular view on how the economy (or a given bank) might react under a given set of stress circumstance, it does no one any good by keeping that view secret. At the very least, the Fed should have sat down with the banks as the stress test was occurring to have a dialogue as to whose assumptions made the most sense. It’s one thing to have failed a regulator-induced stress test. That happens. It’s completely something else to fail the test and not be told specifically why. That’s not regulatory guidance. It’s regulatory randomness.

Remember, too, that the whole stress exercise is an exercise in redundancy. Banking regulators already have the means to ensure the banks they oversee are adequately capitalized, via the minimum required capital standards they have promulgated. Everyone knows what they are. They’re a model of clarity. If a regulator deems that a given bank doesn’t have enough capital, it can simply direct it to raise more. By contrast, the annual stress tests that the banks now must endure are a waste of time and resources. And as we’re seeing, already they’re sowing as much confusion as they are clearing up.

What do you think? Let me know!

4 Responses to “Those Distressing Stress Tests”

  1. jsc173

    Tom — the biggest weapon the regulators have had the past few years is the complete and total uncertainty they bring along with them during an examination. Further, they compound it with the subjective nature of many pieces of the safety and soundness testing they do of a bank’s portfolio. Long story short, it gives them the ability to march into an institution and declare it to be adequately capitalised, or not, depending upon the subjective weighting they’re allowed to employ. This gives them the ability (yeah, I know, sounds like a big conspiracy) to determine the results before they’ve conducted the test. I know they do this because one examiner screwed up a couple of years ago and sent me a spreadsheet with the results of their testing without deleting a portion of one page in the spreadsheet that showed they determined the result they wanted first, and then tweaked the various assumptions to get the desired outcome. When confronted with this the examiner said point blank, “You’re right, but I would never admit to it and you’d be advised not to make a big deal out of it.” In other words, sit down, shut up and we’ll tell you what to do.

  2. ce

    couldn’t agree more… it was more of a game than an effort to find the right economic outcome… i am glad though that we’re not going to get the PNL’s for the banks on a qtrly basis over the next 2 years… that would be annoying.

  3. steve setchfield

    makes no sense to me either, it seems that we really can’t trust what anybody says about the health of banks. im not sure how they have dealt with all the bad mortgages/debts… my assumption is that they don’t have to mark to market any longer so how can we ever know what the true “health” if the bank is?

  4. billybob m

    i might be missing something but to me the stress is one thing, stock buy and dividends are something else. have a stress and then conclude from the test that one needs to raise capital or one can buy back srock or can pay a certain dividend. don’t say you failed the test because you want to pay a dividend. say you passed the test but a dividend is limited.

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