Big banks face a major test this week, when the Federal Reserve carries out the second and more consequential part of its annual stress tests.
The results from the first part of the exam, released last week, reflected well on the health of the financial system. In a hypothetical financial crisis scenario, all 31 banks examined would maintain adequate capital levels to survive, the Fed found.
But this week is the real test, with the Fed set to fail banks if they don’t measure up. The exercise, begun in 2009 to shore up confidence in the soundness of the banking system, can carry serious consequences for banks. If they fail, regulators can stop them from paying out dividends to shareholders or buying back shares, and big bank executives’ jobs could hang in the balance.
Whereas Thursday’s tests analyzed how banks’ balance sheets would hold up if unemployment skyrocketed, stocks and housing prices collapsed, and corporate bond defaults rose, the results to be released Wednesday will involve bank-specific analysis. In particular, the Fed will look at each bank’s plans for raising capital or distributing cash to shareholders, and at qualitative factors that add to the banks’ risk.
A senior Fed official cautioned that the results of the second part of the stress tests could not be guessed at from the first round results. Those showed several banks, including Utah-based Zions Bancorporation, Goldman Sachs, Morgan Stanley, and the U.S. branches of several foreign-owned banks coming close to some regulatory minimums for measures of capital.
That has to have executives at Citigroup, among others, nervous.
Last year, Citigroup was given a failing grade, along with Zions and four foreign-owned banks, causing its shares to plummet and giving its CEO major problems. Multiple reports have suggested that CEO Michael Corbat and other executives could be forced out if Citigroup fails.
After Citigroup was given a failing grade based on its management practices last year, Corbat made it a focus to pass this year. Citigroup has been shedding workers, shrinking its massive global reach, and ramping up compliance over the past few years in part to satisfy regulators.
Since they were first conducted at the bottom of the market collapse in 2009, the stress tests have been a way for regulators to demonstrate that the banking system could withstand a shock. After Thursday’s results, Fed governor Daniel Tarullo expressed satisfaction that the tests demonstrated that banks have raised capital levels since the crisis. “Higher capital levels at large banks increase the resiliency of our financial system,” he said.
Banking industry representatives also echoed the idea that the tests proved the resiliency of the banking system. “These results show the financial industry remains a strong and secure driving force for the growth of the nation’s economy and American jobs,” said Richard Foster, a vice president at the Financial Services Roundtable.
“You have to put a lot of weight on the stress test because whether you pass the stress test or not determines how you manage your company,” said Cornelius Hurley, a Boston University law professor and former Fed official.
Nevertheless, some critics, Hurley included, suggested that the tests are only as meaningful as the underlying regulations they’re testing.
“Instead of restructuring the industry as they should have done, they came up with this menu of prophylactic things that they think will prevent the next financial crisis,” Hurley said, expressing doubt about the minimum capital ratios, liquidity rules, and living wills, and other mechanisms intended to prevent bailouts created by the 2010 Dodd-Frank financial reform law.
“The benchmarks are flawed. To pass that test doesn’t tell me very much,” said Anat Admati, a Stanford finance professor and a co-author of a book, “The Bankers’ New Clothes,” calling for dramatically higher capital standards for banks.
Admati, a critic of Wall Street banks she fears are still too big to fail without getting taxpayer assistance, recommends that banks be forced to retain earnings, rather than pay out dividends, until they have built up equity to the point that there would be little risk of them needing a bailout to pay off a loan.
The stress tests received a separate criticism last week from within the U.S. government, when the Office of Financial Research published a research paper asking if the stress tests, now in their seventh iteration, have become too predictable. The Office of Financial Research was created by Dodd-Frank to help regulators identify and understand financial threats.
“[W]hereas the results of stress tests may be predictable, the results of actual shocks to the financial system are not, and herein lies the concern,” the paper’s authors, two Columbia University professors, wrote. “The process of maturation that makes stress test results more predictable may also make the stress tests less effective.”
