The Week, July 1, 2019: Banks are passing their stress tests with flying colors. Uh oh.
In the aftermath of the 2008 collapse, financial regulators began “stress tests” for banks. These are meant to see if a bank can handle another economic shock. Basically, the Federal Reserve simulates an economic panic of some kind, and then sees how the banks’ business models perform. The latest round of tests concluded last week, and virtually all the big Wall Street players passed with flying colors. The Fed had some reservations about Credit Suisse, but otherwise the 18 biggest banks had enough capital on hand to weather a crisis.
Can we all breathe a sigh of relief that America’s financial system rests on a firm foundation? Unfortunately, maybe not. Over the last few years, policymakers have toned down the “stress” part of the stress tests. Part of the problem is just the practical challenge of simulating an economic crisis. As Mark Whitehouse pointed out, it’s never just the unexpected shock — the burst housing bubble or stock collapse — that’s the problem, it’s all the cascade effects that have to be accounted for in the model too.
The Fed began the tests soon after the Great Recession, as a way to shore up confidence in the U.S. financial system and incentivize the banks to repair their balance sheets. The 2010 Dodd-Frank Act further expanded and entrenched the practice. Then a partial rollback of Dodd-Frank’s regulations was passed by Congress and signed into law by President Trump in May 2018. That law raised the threshold of assets a bank had to have before it faced mandatory annual stress tests, from $50 billion to $250 billion — though banks between the $100 billion and $250 billion mark still face periodic tests. As a result, the number of big banks tested fell from 35 in 2018 to just 18 this year.
Hiding behind all this is the matter of profits: According to the law, passing the stress tests is a hurdle the banks must clear before they can pay out dividends to shareholders. The easier and less strenuous the tests, the bigger and more certain the payouts are. The upshot is that it isn’t at all clear what will happen to the banks when another real-life version of a stress test finally hits. It’s not a comforting thought.
