Fed's Bank Stress Tests: Between Too-Big-To-Fail and Too-Good-To-Be-True

Are the Fed's recent bank stress tests an accurate reflection of economic doomsday prospects or are they merely a temporary tactic to boost faith and confidence in the banking system, the global economy, and the US dollar?

CNBC reported on the most recent string of bank stress tests as being reflective of financial doomsday, a "worst-case scenario". The Fed looked "at how the nation's 19 largest banks would survive a world with a 13 percent jobless rate, a 50-percent drop in stocks, a 21-percent decline in housing prices and a significant contraction of other major world economies." According to CNBC, bank stress tests are "designed to make sure banks have enough cash and cash-like securities to withstand catastrophic losses in a financial crisis."

Though the Fed has interests in making sure that banks have sufficient funds to lend money to consumers and businesses, the fact that the results are made public suggests that bank stress tests work to reassure the marketplace that the financial sector can absorb possible economic headwinds in the near future. Whereas some may argue that the Fed has run out of bullets to spur growth, control inflation, reduce unemployment, and influence the market, bank stress tests could be interpreted as a hidden weapon in spurring economic activity. The most recent stress tests come at a time of substantial uncertainty in the marketplace as the US economy struggles to regain its footing while looking forward to rising oil prices, inflation, Middle East conflicts, Eurozone debt problems, the student loan bubble, and various other socio-economic factors that could form formidable obstacles to recovery.

That being said, alluding to the recent Goldman Sachs GS scandal involving Greg Smith, Bloomberg's Simon Johnson discussed on March 18, 2012 that "Federal Reserve stress tests make us all muppets." Johnson: "As presented by the Fed, most of the news [from the latest bank stress tests] was good. Some large financial institutions were judged likely to have sufficiently equity capital even if the US economy were to experience a significant downturn... Naturally, bank stocks rallied."

Johnson argued that "the Fed's record as an economic forecaster is less than stellar." In this way, the Fed's previous stress tests did not "anticipate the depth and length of the US recession" and did not "envisage even the rough contours of what became the European sovereign debt crisis." Thus, Johnson suggested that whereas the Fed must watch its words in terms of monetary policy and the course of interest rates, the Fed "goes out of its way to convey calmness".

Johnson commented that the Fed's underlying assumption that the Eurozone would only have a mild recession in that "only one large European bank would fail" appears to be "too benign". Johnson also cited the lack of "any serious consideration of interest-rate volatility". Owing to issues such as the viability of the US dollar as a global reserve currency, interest rates could rise in the future. Johnson wrote that "the Fed should examine the implications [of interest-rate volatility] for banks." According to Johnson, "the Fed has an imperfect view of the future, as do we all. It has repeatedly demonstrated a limited ability to control economic outcomes." Whereas the Fed is permitting major banks to reduce capital levels, it is "increasing the likelihood of another financial and fiscal crisis and endangering the broader US economy." Ergo, "We are all muppets now."

Of course, Johnson is not the only one who has concerns regarding the Fed's bank stress tests. The Wall Street Journal's David Benoit discussed on March 20, 2012 that former FDIC chairperson and current senior adviser at the Pew Charitable Trusts "Sheila Bair thinks [that the bank] stress tests missed the point." Benoit: "Some of the biggest banks in the US, including Goldman Sachs Group Inc. GS and JP Morgan Chase JPM, passed the Federal Reserve's stress test but would be considered overleveraged if Sheila Bair were running the examinations."

In an interview with MarketWatch, Bair said that "the whole point of the exercise is to see how these banks would perform in a stressed scenario." Bair later continued, "Unfortunately, the Fed really drove their decision on dividends based on the institutions' risk-based ratios, and I think that was ill-advised. I don't think any capital distribution should be allowed that would bring a bank holding company's leverage ratio below 4% in a stressed environment." Bair discussed that "for institutions in the government safety net, or those the market views as 'too big too fail', there is moral hazard." Thus, a situation where investors can make private gains while the government bears the risk creates "incentives for risk taking." Interestingly, Bair noted that one positive of the most recent Fed bank stress tests is that "the tests are better [because] they are more stressful."

The Huffington Post's Mark Gongloff reported on March 21, 2012 that Fed Chairman cited the results of bank stress tests "as evidence [that] banks are fine". Suggesting that Bernanke is acting like a Jedi master using mind tricks, Gongloff wrote that Bernanke "told Congress that US banks were not the zombie banks we were looking for." Gongloff: "To use another metaphor, America's banking sector is no longer a rickety haunted house of hidden financial disasters waiting to scare us all to death, as it was before the financial crisis, Bernanke told a congressional panel investigating Europe's debt crisis."

Gongloff discussed the concerns of other commentators regarding the Fed's bank stress tests. Per an interview with the Huffington Post, Bloomberg's Simon Johnson said, "The Fed's approach on the stress test, letting the banks pay dividends, was awful, insane. We should be building up capital in banks as buffer." According to Gongloff, critiques of the bank stress tests "have not really done much to slow down the rally in bank stocks... Even Citigroup C, which sort of failed the stress tests -- a characterization the bank hotly disputes -- is up nearly 4 percent." Thus, Gongloff concluded that "Bernanke remains the Jedi master -- at least until reality tests the banks again." Ah yes, good old reality.

Interestingly, Reuters reported Thursday that Fed officials have differing views with respect to the US economy. Whereas Dallas Fed President Richard Fisher has said that "we don't need any more monetary morphine", Bernanke has "sounded more cautious" in light of US consumer spending. Bernanke: "We lack a source of demand to keep the economy growing." And while faith in the US economy is being put to the test, Bernanke recently made comments suggesting that a return to the gold standard would not solve our economic problems, "saying that such a system handicaps the government's ability to address economic conditions". Bernanke: "You need to be attentive to where the economy is and not move too quickly to reverse the policies that are helping the recovery."

Whereas I have previously noted how the word "doomsday" has moved from being a theological concept to being an everyday economic concept, the fact that recent bank stress tests have been regarded as a "doomsday scenario" is quite profound in itself. That being the case, despite Bernanke's views on the results of the recent bank stress tests, one cannot help but notice the formidable economic headwinds that face Americans, in particular, rising food and energy costs and consumer credit issues. That's not even getting into issues related to China's economy slowing, Eurozone debt issues, and increasing Middle East tension. And even then, we cannot lose sight of the long term...with the prospect of the economy coming to a grinding halt in the coming decades -- with potential global problems in terms of the water supply and overpopulation. It would appear that if banks are indeed to be tested according to simulated doomsday standards, when all is said and done, the weight of reality's doomsday that banks would have to shoulder will probably be more burdensome than expected.