Stress Tests Are Vital Tools to Protect Taxpayers and Our Economy

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By Better Markets

Stress tests are critical tools to protect the economy and taxpayers.  Such tests, which regulators conduct on banks to see if they could survive a financial shock without failing, would have been invaluable  before the 2008 crash that cost American families their homes, savings, and jobs (as detailed in our Cost of the Crisis Report).

Stress tests are under assault in this era of Trump administration de-regulation. This is therefore a critical moment to ensure that stress tests continue to be robust and credible. 


 

Read: 12 Better Markets Resources to Help You Make Sense of Stress Tests


 

But everyone should ask how credible a test is when 100% of the test takers pass with flying colors.  That’s usually a red flag that a test isn’t so tough or very good, but Trump’s regulators and the industry are claiming that when all 18 of America’s largest banks passed the Federal Reserve stress test in June that it was a good sign.  We worry that the stress tests are becoming “no-stress stress tests,” giving false and misleading comfort.

That’s just one of the issues we will raise on July 9, 2019 when our President and CEO, Dennis Kelleher, participates in a major Fed conference at the Federal Reserve Bank of Boston.  The Fed is gathering academics, regulators, bankers, and Better Markets, a public interest advocate, for the ”Stress Testing: A Discussion and Review” conference to discuss the transparency and effectiveness of these tests.

Better Markets will be asking if such tests are still protecting Americans in the most effective way possible or if the Trump administration’s adoption of Wall Street’s deregulation agenda is putting Main Street jobs, homes and taxpayers at risk again. We will comment more about that in the days ahead, but today we’d like to equip you with a toolkit of commentary and analyses that can inform your understanding of both the recent tests and the Boston conference.

Background on Stress Testing

The importance of stress tests were made clear during the financial crisis of 2008, and they stand beside capital requirements, leverage ratios, proprietary trading bans, and living wills as the post-crash pillars of financial reform for banks.

Stress tests are conducted on banks by regulators to determine if they could survive a financial shock and not fail, risking contagion and taxpayer bailouts.  They are also used to assess the bank’s ability to absorb losses under different economic downturns and, therefore, their ability to continue to lend to the productive economy.  If banks have enough capital to lend while taking losses, then an economic downturn will be less severe, and the upturn will be quicker.  If, however, banks don’t have enough capital, then they have to rebuild their own capital and withdraw from the lending markets, thereby making the downturn worse and inflicting greater damage on the economy if not the financial system.

The value of stress tests as a tool for stabilizing markets and reassuring the public was proven in 2009, during the heat of the crisis and before the Dodd-Frank Act was passed.   Since then, they have increased in rigor and transparency, and as Daniel Tarullo said, they are now regarded as “the key innovation in capital regulation and supervision,” which makes the other reforms such as enhanced capital standards “more effective.”  (See also Morris Goldstein’s fantastic book, Banking’s Final Exam: Stress Testing and Bank-Capital Reform, for much more information.)

But stress tests are under assault in this era of Trump administration de-regulation, along with many other financial reforms.  Proposals for less frequent testing, the use of less rigorous standards, and even sharing more of the “test questions” with banks threaten to undermine this vitally important regulatory tool.  As Better Markets has advocated in a wide range of comment letters, op-eds, blog-posts, and testimony, some linked below, these measures are unjustified and dangerous.  To provide a meaningful safeguard against another financial crisis, stress tests must remain credible, rigorous, and frequent.

The arguments in favor of weakening the stress testing framework are unsupported and unpersuasive:

  • The stakes are high – Diluting stress tests will increase the likelihood of another crisis, which will cost another staggering $20 trillion or more in lost GDP, along with the incalculable human suffering that swept over the nation in 2008 and for years thereafter.
  • Stress tests have worked – The current regulatory regime has made the financial system safer by making banks safer.  By all accounts, U.S. banks are more resilient than ever and much better able to withstand stress than before the 2008-2009 crisis.  In fact, 2018 was the first year since the financial crisis, and only the third year since 1933, in which not a single bank failed.  Credible stress testing has been a key to this success.
  • Banks are thriving – Banks simply do not need regulatory relief.  With each passing quarter, they set or come close to new records for revenues, profits, and executive bonuses.  And lending levels remain robust.  Clearly, stress tests and financial regulation more broadly have not in any way inhibited the financial sector from being wildly successful according to all financial metrics.
  • It’s too soon to consider relaxing the rules – Regulators simply don’t have sufficient experience to determine whether it is safe and appropriate to alter the stress testing rules by reducing the frequency of stress tests or scaling them back in other ways.  As Governor Brainard has pointed out, it is imperative to “wait[] until we have tested how the new framework performs through a full cycle before we make judgments about its performance.”
  • The risk is amplified given all of the de-regulation underway – The impact of any single de-regulatory step cannot be evaluated in isolation.  Instead, the potential effects must be considered in light of the overall deregulatory environment that now predominates.  And unfortunately, de-regulatory threats to prudential regulation are plentiful, ranging across capital, leverage, trading and liquidity requirements.  The adverse impact of weakening the stress testing framework will be dangerously magnified by these other threats to regulatory reform.

The facts speak for themselves:  Robust and credible stress testing is critical to the ongoing financial stability of the United States.  There is no credible, persuasive reason to change course.

12 Better Markets Resources to Help You Make Sense of Stress Tests

Here are 12 highlights of Better Markets’ scrutiny of stress tests over the years. The first four are our commentary; the latter eight are more complete analyses of stress test rule proposals over the years.

  1. Less Stress Sometimes is a Bad Thing
  2. Stop Wall Street Payouts That Produce TARP Bailouts
  3. Chipping Away at the Most Successful Pillars of Financial Reform, Key Regulators Discuss More Banking Deregulation is On the Way
  4. Financial Reform Newsletter: Protecting America’s Vital Early Warning System to Prevent Financial Crashes & More

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