Fed stress tests find critics on all sides

Supervising large banks can be a thankless task. In a year of extraordinary challenges, the US prudential regulators managed to anger both left and right with their myriad responses to the coronavirus crisis.

Take the Federal Reserve’s unusual stress-testing programme. Top US lenders were subjected to two rounds of tests in 2020, one planned before the outbreak of the public health crisis and another after, plus an ad hoc sensitivity analysis to gauge their resilience to a long-running economic decline in the wake of the pandemic.

The tangle of tests succeeded in alienating bank lobbyists, progressive policy-makers and industry experts all at the same time.

Wall Street’s boosters decried the curbing of dividends and buybacks, which were imposed by the Fed following the first round of tests and eased only a little after the second. They argue the tests show the enduring financial strength of US banks and that buybacks would not undercut their robust capital positions.

In contrast, left-leaning observers, such as those at the Center for American Progress, were aghast that any capital distributions were permitted at all considering the ongoing fragility of the US economy. After all, official US unemployment is around 6.7%, and just 55% of the jobs lost in March and April have been recovered.

Who’s right? The trouble is there’s enough in the stress test results to bolster the arguments of both sides. In the second round of tests published in December, the aggregate Common Equity Tier 1 (CET1) capital ratio of participating banks was projected to slump 260 basis points from peak to trough, a drop of 21%. That sounds severe, but not one bank saw their ratio dip below the 4.5% regulatory minimum.

In addition, the CET1 ratios of some banks – including big names like Morgan Stanley and Goldman Sachs – actually improved in the second round of tests relative to the first, implying they had grown more resilient to a prolonged economic shock.

Using different metrics, though, some of the banks don’t look as healthy. Take the Supplementary Leverage Ratio. Under the second round of tests, five banks were projected to see these fall below the 5% buffer level: Citi, Goldman Sachs, HSBC North America, JP Morgan and Morgan Stanley. This implies they could become hazardously overleveraged over a prolonged period of distress, which isn’t beyond the realm of possibility considering the slow rollout of the Covid vaccine in the US and the risks bubbling up in high-yield credit.

The Fed will have to take these complaints on the chin. The test results are the product of the central bank itself: its models and its assumptions about the economy and how these translate into financial impacts. Those who see the tests as too punitive and those who see them as too lax are apt to cite the Fed’s modelling approach as culpable. The central bank has offered the public a window into the inner workings of its tests, but not enough to quell dissent.

It’s unclear whether further transparency would really bring an end to complaints that the tests are too tough, or not tough enough. As the above examples show, the truth of tests can be interpreted in many ways. It’s the incentives of those doing the observing that determines how they are framed.