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!