The Federal Reserve Board’s annual stress tests, started in 2009, are complex, time consuming and an exacting process. The goal to determine if the banks have enough capital to withstand the impact of adverse developments and still remain viable. The tests start with the developing and publishing of 3 economic scenarios that demonstrate various degrees of economic stress: a baseline, an adverse, and an extremely adverse. The scenarios consider not just isolated events, but also the ancillary effects of said event.
With that said, it appears that the Fed is thorough and the process should be sound.
Yet, some detractors say the stress tests are a sham. When the tests were initiated, David Stockman, author of The Great Defamation: The Corruption of Capitalism in America, skewered the tests and wrote, “The key problem with the whole stress test exercise is that it does nothing to improve financial system transparency.”
Stockman claims the tests are a joke. He cited Bank of America (BofA) as sailing through the first two testing rounds: the quantitative number crunching and the Comprehensive Capital Analysis and Review. Yet, after Bank of America passed both rounds and got approval to reward their shareholders for its (the bank’s) good capital management, they notified the Fed that they had miscalculated its capital by a few billion dollars – that’s right, billion!
It seems that BofA had been submitting inaccurate numbers since 2009. Yet, they had consistently passed the Fed stress tests. Stockman says that it gets worse. According to Columbia University researchers, Paul Glasserman and Gowtham Tangirala, authors of a working paper, Are the Federal Reserve’s Stress Test Results Predictable, from the U.S. Department of the Treasury’s Office of Financial Research (March 3, 2015), all of the top stress tested banks are remarkably similar in testing outcomes.
How could that be? The authors say, “the banks go in remarkably alike.” So of course they would come out remarkably alike as well. “The results are striking. The patterns appear to be an artifact of the bank stress testing process rather than an accurate reflection of potential bank losses. The main concern with a routinized stress test is the danger that it will lead banks to optimize their choices for a particular supervisory hurdle and implicitly create new, harder-to-detect risks in doing so. This concern applies to any fixed supervisory scheme, including one based on risk-weighted assets”.
There are huge issues here. Most of the banks use the same consultants to guide them through the tests, often former Fed regulators from the agencies conducting these test!
According to Stockman, “the banks are connected dominoes.” And you know what happens if one domino falls down!
You have to question this process when two of the biggest banks, Deutsche Bank and Santander Holdings USA, Inc., can fail the bank stress tests and others make major reporting gaffes. Something is wrong when four of the biggest banks on Wall Street struggle to pass the 2015 tests: Goldman Sachs, J.P. Morgan Chase & Co., Morgan Stanley and Bank of America – ALL had to make adjustments of some kind.
Stockman says, “The only thing the stress tests tell us is if capital requirements, reserve requirements, and other buffers aren’t enough to protect the financial system from its own greed.”
It doesn’t appear as if stress testing the banks is the answer; in fact, quite the reverse. Stockman and I both ask: is the answer breaking up the big banks before they go down the 2008 path once again and break the economy?
And shouldn’t we also be asking, are stress tests a placebo or a deliberate misdiagnosis?