Additional Testing Required

Update 450 — Additional Testing Required:
What to Expect from the Fed’s Stress Tests

In a month, we will celebrate the 10th anniversary of the signing of the Dodd-Frank Act, which codified annual Federal Reserve stress testing of major financial institutions to see if they can withstand various hypothetical macroeconomic hardships. No one contemplated COVID then, of course. 

Tomorrow, the Fed will announce results of this year’s stress tests.  No need for hypotheticals in 2020. What will the results show? Will news about the sturdiness of big banks provide credible reassurance as it did in 2009, when it all but single-handedly stopped the economic and capital markets free fall in its tracks? Why not? See below…

Best, 

Dana

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When the Federal Reserve releases the results of its stress tests for the country’s 34 largest banks tomorrow, eyes will be watching for failures. Last year, banks skated by without a single one. This year’s tests could be less relevant — even in the midst of a crisis — given that the Fed set the test criteria before the pandemic hit and the data reflects banks’ balance sheets as of last December. Additionally, the Fed and the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) of 2019 significantly weakened the stress tests.

Below, we analyze the evolution of the stress tests, forecast what we might see tomorrow, and assess the Fed’s massive macro response. 

Once Powerful, Now Weakened

Banking regulators use the Fed’s annual stress tests to assess the adequacy of banks’ capital under difficult economic conditions. The Fed tests how banks’ balance sheets would fare should GDP contract, stock prices plunge, and unemployment rise. If a bank does not have adequate capital, the Fed may restrict the bank from issuing dividends or performing stock buybacks. Arguably worse than the actual penalty is the public shaming in the markets should a bank fail.

The current stress test regime began with the 2008 financial crisis. Before the financial crisis, banks only conducted stress tests internally. The Fed’s release of its first stress test results in May 2009, which showed that 10 of the 19 largest banks had inadequate capital, was a turning point in the crisis. As a result, banks issued more equity to shore up their balance sheets, which helped restore investor confidence. The 2009 tests were regarded in the markets as a success, and stress tests became a part of the enhanced prudential standards.

The Fed has given out only one failing grade since 2018, leading some to question the efficacy of this oversight tool. While banks are better capitalized due to Dodd-Frank reforms, the Fed also weakened the stress tests starting in 2019 by: 

  • Moving Away from Pass/Fail: The stress tests have two portions, one that assesses banks’ capital under a “quantitative” test and another that assesses banks’ internal risk management under a “qualitative” test. Banks have been more likely to fail under the qualitative portion, prompting them to push back on the grounds that it’s more subjective. The Fed lowered the stakes of the qualitative tests, allowing banks to bypass a public Pass/Fail grade if they take the test for four years and pass in the most recent year.
  • The “Textbook”:  In the name of greater transparency, the Fed agreed to release more information to banks about test structures. This concession allows banks to more easily game the system by tailoring their capital plans to meet the test requirements. While critics say this gives banks the questions ahead of the test, Fed Vice Chair Quarles said it’s more like giving banks a “textbook to prepare.”
  • Biennial Tests: The Fed now only tests banks with between $100 and $250 billion in assets on a biennial basis because of the rollback in the EGRRCPA. Some of the larger banks have also pushed to go on a biennial schedule. This year, the Fed is testing the full suite of banks.

COVID – The Real Stress Test

The Fed will report the 2020 stress test results at the aggregate- and firm-level on Thursday. Forecasters expect that, similar to last year, banks will pass fairly easily.

This year’s test scenario was set in February and does not take into account the crisis at hand. Also, the tests are against the banks’ balance sheets from December 2019, a period when the economy was much healthier. The current crisis is arguably harder than the test criteria. Unemployment is hovering around 13 percent, and the Congressional Budget Office projects a 39.6 annualized drop in GDP in Q2. The Fed’s hypothetical “severe” scenario has U.S. GDP dropping 8.5 percent and unemployment hitting 10 percent by Q3 2021. Needless to say, the COVID crisis is much more stressful than this hypothetical “doomsday scenario.”

Additional Testing Required

As a result of the test not being relevant to the current crisis, Fed Vice Chair Randal Quarles announced in April that the banks would undergo additional COVID sensitivity analyses. The additional tests will assess how banks will undergo the stresses of a “V,”  “U,” and  “W” shaped recovery. Failure in any one of these scenarios could result in the Fed potentially restricting dividend payouts. While the Fed will report the results of these tests, they will only release aggregate-level data, not firm-level data, leaving the public without full knowledge of any hobbled banks within the financial system.

Throughout this crisis, U.S. banks have continued to issue dividends, even while banks in Europe and the UK have suspended this practice. In April, Sens. Schatz, Brown, and Warren urged Fed Chair Jerome Powell to restrict bank dividends. They argued that should this be a drawn-out recession, banks should focus on lending to their communities, not repurchasing stocks or paying executive bonuses.

Reaching the Fed’s Limit

The coronavirus crisis has caused one of the most acute economic crises since the Great Depression. But unlike in 2009, the crisis is not centered in the banking sector. The banks — with significant assistance from the Fed — have so far been able to weather the current crisis. Unlike in 2008, the Fed was immediately prepared to step in with emergency lending facilities to ensure that the financial sector remained liquid. The Fed’s balance sheet ballooned from roughly $4.1 trillion in February to $7.1 trillion today. Even before the coronavirus crisis began, the Fed was pumping hundreds of billions of dollars into the repo market.  

All of the facilities rely on recipients being illiquid but fundamentally solvent. The Fed has Herculean powers to keep banks liquid, but it can’t save them from a solvency crisis. As Fed Chair Powell has said numerous times during this crisis, the Fed has lending powers, not spending powers. If the crisis drags on and we face a prolonged “U” or “W” recovery, more businesses will go under, further stressing banks’ balance sheets.

Barring the public from seeing the individual bank-level results from the COVID sensitivity tests undermines the purpose of the tests. When more than half of the banks failed the 2009 stress test, it served as a wake-up call for banks to bolster their balance sheets and restored confidence in the market. Giving the public more information to assess the actual health of the banks will help drive policy to ensure businesses remain solvent throughout the crisis. Congress has the fiscal power to keep the economy from spiraling further downward, but it needs credible data to make those decisions. 

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