The Federal Reserve faces a reckoning: Sometime soon, it’ll probably have to subject its stress tests to public scrutiny, highlighting serious flaws in what has become its primary tool for ensuring the resilience of the banking system.
Hopefully, it’ll take this as an opportunity for improvement. Failing that, it should reconsider its reliance on the exercise.
Stress tests can be immensely valuable: In 2009, they helped pull the global financial system back from collapse, shedding much-needed light on banks’ balance sheets and restoring the confidence needed to recover. Less so, though, is the annual process that has followed, in which the Fed tries to assess whether banks can survive hypothetical worst-case scenarios.
Although it initially pushed executives to improve risk management and reduce reliance on borrowed money, it has become a predictable exercise that largely fails to mimic real crises — and hence creates a false sense of security. At the four largest US banks, loss-absorbing equity capital as a share of total exposure has declined significantly from its peak in 2017.
Nonetheless, in 2020, the Fed made the tests a direct determinant of capital requirements for large banks. Intended to streamline the process, the move has satisfied nobody. For one, it leaves banks with much less equity than research suggests they need. Banks, for their part, say that the requirements change too much from year to year, depending on the details of the exercise. Also, in a recent lawsuit, they argue that the Fed shouldn’t be allowed to set such consequential requirements based on models over which they have almost no say.
The Fed is proposing a big rework. It’ll publish its models for public comment, and every year it will open its scenarios to feedback well in advance, giving the industry at least a month to offer criticism that will need to be reflected in the final version. It also suggests averaging results over two years to minimize volatility in the requirements.
Sensible as the Fed’s new approach may be, it risks weakening the tests further. Allowing for 30 to 60 days of comment, then re-proposing, will be a cumbersome and contentious process. Both real and potential challenges from banks will pressure officials to make the tests less stressful, if only to avoid time-consuming conflict. The likely result will be a less resilient system.
No doubt, the Fed recognizes the pitfalls. One must hope that the public exposure will instead lead it to improve the tests — for example, by including the feedback loops and other effects that make real crises so damaging. Ideally, this would produce capital levels that are both higher and better attuned to the risks banks face.
Otherwise, the Fed should consider decoupling the stress tests from its capital requirements, using them only as an input in deciding how much equity banks need. The approach would be blunter, but it would at least leave the US better prepared when the next crisis inevitably comes.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
More Smart Beta Topics >
