Bank stress tests are no test at all
The Federal Reserve announced earlier this month the results of its much-heralded stress tests of major banks mandated by the 2010 Dodd-Frank financial legislation.
Seventeen of the 18 largest passed, sparking criticism that the tests reflected political maneuvering rather than a true assessment of risks. Amazingly, the Fed deemed banks impervious to interest rate risks.
“It's a very good exercise to do, showing everyone that the U.S. banking system is well capitalized,” said Gerard Cassidy, a Royal Bank of Scotland analyst.
On the other hand, Rebel A. Cole, a DePaul University finance professor, said “the stress tests were not very stressful.”
The testing became law because the real estate crash of 2007-08 exposed risk-taking at banks amounting to gambling and dishonesty. In aggregate, Wall Street paid itself over $22 billion in bonuses in 2006. Deemed too big to fail, the government forced taxpayers to bail out the big banks. Some banks were fined but allowed to deny guilt. No senior bank executives were jailed.
Since then, the banks have grown even larger — accompanied by increased systemic risk. However, with access to zero-cost money from the Fed and interest paid on their excess deposits with the Fed, banks have generated stacks of cash and capital based on relatively risk-free investment in Treasury securities.
These Treasury investments are massive. Despite Standard and Poors downgrading Treasury debt, bank regulators have allowed U.S. banks to treat them as AAA-grade securities.
The most severe stress test the banks were put through painted a scenario of falling real disposable consumer income over five consecutive quarters, 12.1 percent unemployment, equities falling by 52 percent and housing prices declining by 21 percent. These criteria may be considered extreme. But they are not far from what happened in the 2007-08 Great Recession under President George W. Bush. Then, despite government bailouts of unimaginable size, stock markets fell by some 57 percent and housing prices by almost 30 percent.
Some wrangling occurred between banks and Fed officials over the conduct of the tests, as reported by The New York Times. Banks' results, critics say, tended to be rosier that those calculated by the Fed.
The fact that Morgan Stanley and Goldman Sachs came out near the bottom was not surprising. They are basically risk-taking investment banks that are shielded by commercial banking status. Citi came out well, surprising some. But Citi had sold its investment bank, Smith Barney, lessening risks.
The judgmental assessment of bank risk for various asset classes is qualitative, creating the potential for disagreement.
The possibility of a market-inspired upturn in interest rates outweighing the Fed's downward pressure represents a huge risk to the price of Treasury securities. As the banks have accumulated massive amounts of these securities to avoid more risky corporate lending, the exclusion of this risk renders the stress tests almost meaningless.
Interest rates are more likely to rise than to fall, eroding bond prices. A substantial rise, however, could unleash a second, far more damaging, banking collapse.
John Browne, a former member of Britain's Parliament, is a financial and economics columnist for Total Trib Media. Email him at firstname.lastname@example.org.