Testing What Stress How?

On Thursday, the Fed released its 2013 “Comprehensive Capital Analysis and Review” (CCAR)—part 2 of the Fed’s latest round of bank stress tests. The good news is most banks sailed through. The bad news is the stress tests are still an excellent, rearview-mirror look at past consequences of some form of systemic weakness with little predictive or preventive value.

The first part of the stress tests measured whether major bank holding companies (BHC) currently have sufficient capital buffers to weather very specific adverse economic conditions, chosen by the Fed. And all major banks, save one, passed that hurdle.

Somewhat understandably, that one bank took issue with their failing marks. To start, the bank in question happens to be majority-owned by the government. So the government gave the bank a failing grade for being ill-prepared ... by the government? But nevermind.

Evidently, the bank’s own calculations yielded passing grades which they can’t square with the Fed’s findings. They wanted to know just how the Fed crunched its data—a perfectly reasonable request. The Fed’s response was, “Sorry, we don’t disclose our methodology.”

It’s an odd bit of dissonance, since Mr. Bernanke’s Fed has sold itself as being the most transparent Fed in history. And it mostly has been remarkably transparent, going so far as to clearly broadcast what exact markers it’s looking for to raise rates, and when they think that might happen. Transparency is great! More transparency is preferable in nearly every factor of business and life (save, perhaps, sausage making). But keep in mind, more transparency on its own doesn’t necessarily translate into smarter monetary policy. The Fed’s policy over the past few years has been remarkably transparent—and contractionary. Alan Greenspan arguably still reigns as history’s best Fed head (he had his failings, they all do), and he was famous for talking a lot while saying zilch.

Which brings us to today’s results. The first test measured a point in time—do banks have, at this moment, adequate capital ratios? Whereas the CCAR aimed to measure how the banks’ capital plans (i.e., planned dividend distributions, any stock issuances or buybacks, any debt issuances, retiring debt, etc.) for the next 2.25 years (a very specific time frame chosen by the Fed) might impact those ratios given those same adverse condition assumptions. The Fed measured them on a quantitative basis (were their capital ratios at or above the Fed’s target level) and a qualitative basis (did the banks adequately address potential risks and internal controls).

Of the 18 BHCs measured, 14 passed—the Fed issued “non-objections” to their capital plans and they may implement away. Two BHCs got “conditional non-objections.” This means their ratios were fine, but the Fed found something wanting in their qualitative analysis. That doesn’t necessarily mean the banks lack proper internal controls or plans for a range of adverse conditions. It may simply be those BHCs failed the essay portion. Hence, they have 2 quarters to resubmit their plans, but in the meantime, they may move forward.

Two banks received “objections.” All is not lost—they must go think about what they’ve done and resubmit plans for approval. Until then, they may not implement any capital actions—which isn’t ideal for them. Unsurprisingly, one of the failing banks was the self-same one objecting to the Fed’s lack of transparency.

So, again we are delivered evidence that US banks overall have much beefier capital ratios and generally are in better shape. Which is good—if beefy capital ratios and only beefy capital ratios matter. (Would be nicer if, in addition, banks were also keen to lend more—a desire the Fed has been dumping ice water on with its QE-infinity policy.) But because the Fed isn’t much interested in revealing the reasoning or methodology behind its assumptions and calculations, we don’t have much evidence the stress tests can predict or prevent future weakness.