Global Market Commentary

July 03, 2014

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Regulators are Forcing Banks to Get More Conservative

Last Wednesday, Federal Reserve governor Daniel Tarullo addressed the Fed’s symposium on stress test modelling. This is a now-annual gathering of Fed officials and financial industry participants, where the discussion focuses on the Fed’s efforts to evaluate the strength of banks in the face of a variety of possible scenarios
for economic crisis or market downturn.

Tarullo, a law professor at Georgetown University, was appointed to the Fed’s Board of Governors during the financial crisis in 2009. He oversees regulatory matters for the Fed, so attendees paid particular attention to his address for clues about how the Fed’s regulatory regime for significant financial institutions will develop.

Tarullo’s message to big banks and those who might invest in them: Don’t rest easy — our test models are going to continue to change, adapt to current and anticipated conditions, and get tougher.

Passing Stress Tests Is Critical For Banks’ Capital Plans

A stress test allows regulators to evaluate a financial institution’s resiliency to crisis. During the financial crisis of 2008 and 2009, stress tests were applied simultaneously to the largest financial institutions in regulators’ attempts to understand the firms’ exposure to various potential risks. That Supervisory Capital Assessment Program (SCAP) was conducted in circumstances that then-chair Ben Bernanke described as “the fog of war.” But it proved critical in demonstrating the value of forward-looking risk analysis that doesn’t consider each firm individually, but many large firms as a systemic whole.



Stress Tests



Since that time, stress tests have become a regular feature of central bank regulatory policy in both the U.S. and Europe, with the European Central Bank (ECB) making them a centerpiece of their new role as the Eurozone’s main banking supervisor. These tests are viewed with intense concern by banks and investors, since they largely govern how much capital banks are able to return to investors in the form of dividends or share buybacks.

In the U.S., stress tests have matured from the ad hoc tool employed at Stress Tests Have “Encouraged” Banks To Have Healthier Capital Ratios the height of the crisis into a regular annual event. The approach has remained generally the same as in SCAP, but has developed in a few notable ways that Tarullo emphasized in his speech. We think it’s worth observing what the Fed regulators think is good about the program — since that gives an indication of what probably lies ahead for banks.

What Makes Current Stress Tests More Robust, in the Fed’s View

Tarullo noted many of the ways in which the Fed’s stress tests have gotten tougher over the past five years.  For example, when SCAP was first applied, the Fed had to rely on banks’ own estimates of losses and revenues in its analysis of various scenarios. Since then, the Fed has been able to collect more data and generate its own independent estimates, not just take the banks’ word for it.

Also, the Fed’s models have moved from simple recession/crisis scenarios to more elaborate macroeconomic situations, incorporating metrics not directly related to the business cycle. The Fed has also explicitly modeled how each firm would be affected by the default of its largest counterparty — potentially exposing otherwise undetected systemic risks.

More Ideas Coming

Throughout his remarks, Tarullo suggested that it was the dynamic quality of the stress tests that was most significant.  In other words, banks will not be able to adjust themselves to expected metrics and then expect to pass easily. The tests will be a constantly moving target.  

Greater Transparency and Greater Scrutiny Have Arrived, and Will Continue to Grow for Too-Big-to-Fail

Institutions Notably, Tarullo also pointed out the benefits of greater transparency in the Fed’s stress testing. By this he didn’t mean the disclosure of the models the Fed uses. As he noted, “We do not want firms simply to copy our modeling in their own assessment of risks and capital needs. And we certainly do not want them to construct their portfolios in an effort to game the model.” The Fed subjects its models to independent scrutiny by independent internal and external auditors — but doesn’t show them to the financial industry. The transparency Tarullo referred to in his address was for the public:

“Because bank portfolios are often quite opaque and thus difficult for outsiders to value, this information should allow investors, counterparties, analysts, and markets more generally to make more informed judgments on the condition of U.S. banking institutions.” In other words, the results of stress tests will make clear to the public the true conditions of banks’ balance sheets that might otherwise be extremely difficult to evaluate.

Tarullo also noted the Fed’s intention to incorporate the stress-test standards into the Fed’s overall supervisory activities — in other words, banks won’t be able to “cram” for a once-a-year stress test, but will be examined for their adherence to risk management and capital planning standards on a continuous basis.

So his address suggests not only that the Fed will continue to develop stress tests in an effort to be more creative in uncovering banks’ weaknesses, but that it will publicize the results of those tests for closer scrutiny by the investing public — measures that he believes will “increase market discipline.”

We agree that it has the potential do that, provided the development of stress tests is robust. We are happy to see Fed regulators expressing these intentions. Further, as investors, these reflections lead us to believe that the Fed’s scrutiny of “too big to fail” institutions is likely only to become more extensive, more stringent, and more public.

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