The results are in. Last week the Federal Reserve reported the findings of the financial industry’s annual health check.
The Fed tested 18 banks (which together account for over 70% of total bank assets in US) to see how they would hold up in a severe recession that brought the jobless rate up to 12.1%, the equity market down more than 50%, and housing prices down more than 20%. To pass, banks have to be able to maintain a minimum 5% capital cushion under that scenario.
Of the 18 banks the Fed put under the microscope, all but one passed. Ally Financial failed as it only managed to keep up a 1.5% capital buffer (Goldman Sachs and Morgan Stanley also scraped by near the bottom of the list). But all in all, the 18 banks aggregate capital cushion would be 7.4%…an improvement over the 5.6% result from the end of 2008…leading the Fed to say that banks are “collectively in a much stronger capital position than before the financial crisis”.
And under the stress scenario, altogether the 18 banks would lose a combined $462 billion.
The banks ran the same stress test on their own, and not surprisingly, the results turned out to be quite a bit more optimistic. In its own testing, Wells Fargo ended up with a 9.2% buffer…much comfier than the Fed’s 7%. Bank of America came up with 7.7%, better than the Fed’s estimate of 6.8%. Morgan Stanley gave itself a 6.7% ratio while the Fed gave it 5.7%, and JPMorgan estimated 7.6% as opposed to the Fed’s 6.3%.
The discrepancy between the Fed’s results and what banks came up with is a reminder that the stress test serves a different purpose for everyone. As BusinessWeek aptly pointed out: For lawmakers, the tests should produce a result. For the Fed, the tests should prove that banks are safe. For the banks, the tests should prove that they should be allowed to distribute capital to shareholders. And for taxpayers, the tests should show that we will never have to fork over money to rescue the financial industry again.
The stress tests have been criticized as being too lenient and giving banks an “easy A”. The tests are not ‘stressful enough’ and underestimate potential losses and fail to capture all the forces that drive events during a crisis.
Ultimately, the Fed is trying to stress test banks assuming it knows what is going to go wrong in the future. And in reality, what are the chances that a crisis would occur just the way they planned it?