Why the Bank Stress Tests Don't Really Matter

by Edward O'Brien 0

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There’s evidence the Fed graded its stress tests on a curve this year.

For all the hullabaloo about the stress tests, the truth is the Fed is making bank executives sweat a little less than it used to. What’s more, after six years of doing these annual tests, the incentive for banks to do well is eroding: It turns out the penalty for not fully passing is essentially nil.

On Wednesday, the Federal Reserve announced that nearly every big bank unconditionally passed its annual stress test, with the notable exception of Morgan Stanley MS -3.20% among U.S.-based firms.

“Over the six years in which [Comprehensive Capital Analysis and Review] has been in place, the participating firms have strengthened their capital positions and improved their risk-management capacities,” Fed governor Daniel Tarullo said in a release.
But what the U.S.’s primary bank regulator didn’t broadcast, nor did any of the individual banks, is that the test was a whole less easier than it was last year—at least for the big banks.

For the nation’s six-largest banks; Bank of America, Citigroup, Goldman Sachs, J.P. Morgan Chase, Morgan Stanley, Wells Fargo; the Fed estimated this year that even after a severe economic shock the banks would have more than enough capital to cover losses—8.4% of their risk-weighted assets on average. That was up from an average of just over 7% in the stress test a year ago, and by far the best outcome for the banks since the financial crisis. Get down to very low capital levels and you are out of business. Below 5% is considered failing the test.

With the economy performing more strongly in many market sectors, meeting stress test requirements are becoming relatively easier, particularly for larger banks. Even though most of the big banks are reporting stronger stress test results, they must prepare for both future economic downturns, and the possibility, however unlikely, of operating in a negative interest rate environment. One of the most effective ways to strengthen their capital positions can be by making their operations more efficient through channels and process innovations, which can create substantial opportunities for increased capital creation and profitability.

Overview by Ed O’Brien, Director, Banking Channels Advisory Service at Mercator Advisory Group

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