The following editorial appears on Bloomberg Opinion.
This week, the Federal Reserve will release results from its most recent round of stress tests, in which it subjected the country’s largest banks to a hypothetical economic slump and market meltdown. Most if not all of the participants will pass, suggesting that they’re amply capitalized and can safely pay out more of their income to shareholders.
Unfortunately, the banks aren’t as safe as they look. The results are misleading, and the more people believe them, the more likely another crisis becomes.
The tests have never been as tough as they need to be. For one, they don’t capture important second-round effects — such as how financial and economic distress, as well as cash crunches and asset sales, reinforce one another to amplify losses. This means that even the harshest-looking hypothetical scenarios don’t come close to mimicking a real crisis. Moreover, the tests are getting less stressful as the memory of the 2008 crisis fades: The 2018 exercise simulated a combined net loss of just 0.7% of assets at the four largest banks, less than half what they endured in the 2013 round.
The Fed should be toughening up these tests and acting on the results more energetically. In fact, it’s pushing in the other direction.
Consider risk management. The stress tests did a lot to improve practices, in part by making banks think for themselves. The Fed withheld information about its loss-estimation model, to force banks to design their own. If they weren’t hard enough on themselves, the central bank could publicly reject their plans to pay dividends and buy back stock. And if it concluded that they didn’t understand the risks they faced, it could flunk them on “qualitative” grounds.
Now the Fed is moving toward “enhanced transparency,” which will actually shed less light on banks’ risks. It has released details of its model, making the exercise more like an open-book exam. It intends to give banks the results before they submit plans to pay out capital, so they can make any necessary changes without drawing attention. And it has largely eliminated the qualitative objection, so the world may never know about the deficiencies it finds. All this reduces incentives for the banks to get a firm grasp of how things might go wrong.
Worse, the Fed’s new head of bank supervision, Randal Quarles, wants to soften the tests in another way, by removing a requirement that banks stay above a minimum leverage ratio. This simple ratio of equity to assets was designed as a backstop to regulatory capital ratios, which place smaller weights on safer assets but can miss important risks. In previous tests, it has proven to be the toughest hurdle for banks to surmount.
If banks were truly well capitalized, regular stress tests wouldn’t be necessary: They could be rolled out only when needed to bolster confidence in actual crises, like the first round of U.S. tests in 2009. Sadly, that’s not the case. On average, the six largest banks have about $7 in equity for each $100 in assets. That’s less than half what economists at the Minneapolis Fed estimate they need to make bailouts acceptably unlikely.
In this imperfect world, stress tests play an important role in ensuring at least a modicum of loss-absorbing capacity, so it’s crucial that legislators and regulators seek to improve rather than weaken them. As things stand, the tests shouldn’t be seen as confirming that the banking system could cope with a crisis. Complacency might help to bring on the next one.