Stephen Cecchetti is a professor at the Brandeis International Business School, and Kim Schoenholtz is a professor at the NYU Stern School of Business. They blog at www.moneyandbanking.com. Here they argue that the US Federal Reserve’s plans to keep the results of its forthcoming stress tests for individual banks out of public view will backfire. An announcement is set to come from the Fed today at 4.30pm Eastern time on the test results.
The Federal Reserve said last week that it plans to limit the disclosure of this year’s large bank stress tests. An announcement of the results is due later today. If it goes ahead with the plans, they are likely to prove self-defeating.
Failure to disclose the individual banks’ outcomes of this year’s Covid-19 “sensitivity analysis” tests will weaken the credibility and effectiveness of the Fed’s stress testing regime. To put it bluntly, the main point of a supervisory stress test is disclosure. Anything short of full transparency risks financial instability.
There are three key elements of an effective stress testing regime that have characterised the Fed’s tests since the extraordinary 2009 Supervisory Capital Assessment Program (SCAP). These are severity, flexibility, and transparency.
First, if stress test scenarios are not dire enough, there is little use in doing them. Second, effective tests must include scenarios that adapt—sometimes rapidly—to changing economic and financial conditions. Third, scenarios should be transparent after the fact, not before. To promote confidence and effective market function in the presence of a large shock, supervisors must disclose the results of individual institutions. Failure to disaggregate fosters concerns about the presence of weak banks and can lead to runs.
Experience with the May 2009 SCAP, with its bank-by-bank detail, highlights the favourable impact of full disclosure. Following publication, the largest US banks were again able to tap the equity market to help them lend to healthy borrowers. Because the SCAP played such a critical role in ending the Great Financial Crisis (GFC), many observers (including ourselves) view it as the most successful stress test in history.
Against this background, we found the Fed’s May announcement of its intention to supplement the scenarios announced in February with a Covid-related sensitivity analysis quite heartening. Based on current economic indicators, the impact of Covid is significantly worse than the severely adverse scenario provided in February. While market developments are generally better than in those in the severely adverse scenario, ensuring confidence in the banks requires that we have some sense of both their post-Covid state and of their ability to withstand further deterioration in economic conditions.
The clear lesson from history is that episodes of sizeable shocks to bank capital are precisely the times when the disclosure of individual bank stress test results can foster confidence. The scale of the current shock is very large: as of June 19, the NYU Stern Volatility Lab’s measure of SRISK—a market-based estimate of banks’ capital shortfalls—puts the aggregate capital shortfall of US intermediaries near the peaks observed in 2008-09.
Moreover, the Federal Reserve in recent years unwisely permitted the largest US banks to make shareholder payouts (summing dividends and share buybacks) in excess of their earnings. As a result, in the final years of the decade-long cyclical expansion, when banks should have been building their capital buffers to improve resilience, supervisors tolerated a persistent decline in the regulatory leverage ratios of the largest US banks.
Finally, we face an uncertain recovery that is liable to include rising defaults. This, together with the likelihood of a flat yield curve for some time to come, means that there is little hope of using bank profits to replenish capital anytime soon.
With these worrisome prospects, and in light of what made the 2009 SCAP successful, it seems natural to expect that the Fed would indeed publish individual results from the “downside risk paths” in the Covid-19 sensitivity analysis.
If US large banks remain healthy under these simulations, then the Fed has a powerful incentive to release the full results. Conversely, providing only an aggregate result would invite doubt about the wellbeing of one or more banks, and could unintentionally increase stress in the system.
Moreover, it is difficult to see how the Fed’s effort to limit disclosure won’t end up being largely futile. The uncertainty about individual banks will encourage the healthiest institutions to disclose their full sensitivity results as soon as possible. And, given the potentially material nature, securities law may oblige other banks to report theirs, too.
There are two things that the Fed should do immediately to enhance financial stability. First, release a complete set of individual banks’ test results. Second, issue a temporary rule prohibiting all the stress test banks from any voluntary pay-outs (including dividends, bonuses and share repurchases).
A rule restricting payouts for the time being would help the weakest players build resiliency while limiting the stigma associated with any individual institution’s actions. Considering the risks ahead, and in light of the strength of the US equity market, calling on all the banks now to issue more equity (as Federal Reserve Bank of Minneapolis President Neel Kashkari has done) could prove even more effective.
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June 25, 2020 at 07:34PM
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If the Fed puts its stress test results in the shadows, it will backfire - FT Alphaville
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