Category Archive 'The Federal Reserve'

06 Mar 2020

The Illusion of Control

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Bob Henderson found that there is nothing like losing $200 million during the 2008 financial crisis to concentrate the mind.

[T]he Federal Reserve… has conducted stress tests on the biggest banks every year since the crisis [of 2008]. The Fed’s goal is the same as mine was in September 2008: to calculate how bad things might get. In the Fed’s case, that means testing what might happen to the banks’ capital (assets minus debts) in a crisis when assets depreciate. Negative capital is called insolvency. For a bank, insolvency is a fast track to bankruptcy. In “supervisory” stress testing, regulators like the Fed—this is being done in Europe too—posit one or more worst-case scenarios and compute the consequences for capital, similar to how I tried to calculate how much I’d lose in a crash.

The Fed’s first test in 2009 was an unmitigated success, widely credited with ending the most acute stage of the crisis. The test was based on a scenario in which the market tanked even further than it already had and a deep recession followed. The Fed concluded that several big banks would suffer capital shortfalls as a result, Bank of America leading the list with a deficit of $33 billion. The Treasury Department then topped off the needy banks with cash from its Troubled Asset Relief Program, reassuring markets and kick-starting a recovery.

Now, the Fed stress tests the big banks every year, partly because the chief piece of post-crisis financial regulation in the U.S., the 2010 Dodd-Frank Act, requires it. Banks have long operated under regulatory capital limits, such as minimum ratios of capital to assets. What’s new since the crisis is that those minima have increased and that stress testing is used to regulate banks’ capital plans—limiting share buybacks and dividend payments, for example—to try to guarantee that they’ll have sufficient capital no matter what.

The Fed’s test in 2015 concluded that the 31 largest bank holding companies in the U.S., which account for more than 80 percent of the country’s banking assets, would lose a grand total of $490 billion in its worst-case scenario. And yet, for the first time in the tests’ history, not a single bank failed the test by having its capital to asset ratio fall below the Fed’s 5 percent hurdle. The implication was that the banks were finally under control.

Or was it just an illusion of control?

I took a look at the Fed’s stress test scenario1 myself recently, on the bank’s website. My first reaction was that it seemed almost farcically fashioned to “fight the last war”: The Dow drops by about half, U.S. GDP dips around 5 percent, unemployment spikes to 10 percent—basically it’s the aftermath of 2008 all over again. It doesn’t account for other potential calamities, like a breakup of the Euro, for example, or an emerging market crisis, or hyperinflation, or shock-induced feedback effects like the ones I faced with fuel.

There’s also the inconvenient fact that both Fannie Mae and Freddie Mac were stress tested regularly by their regulator, and declared well capitalized—right up until they failed in 2008. The same was true for Iceland’s banks.

I’m not alone in my skepticism. The former Fed economist Til Schuermann, who had a hand in designing the Fed’s tests, thinks that they actually add risk to the system, rather than reduce it, a position he outlined in a 2013 Wall Street Journal op-ed. “The danger is that the financial system and its regulators are moving to a narrow risk-model gene pool that is highly vulnerable to the next financial virus,” he wrote. “By discouraging innovation in risk models, we risk sowing the seeds of our next systemic crisis.”

In other words, the Fed, by centralizing stress testing around its own approach, is incentivizing banks to follow suit, which may push them to accumulate similar exposures to one another and to manage them in similar ways, resulting in decreased diversification and increased risk. This is a question raised by particularly prescriptive rules like the Fed’s 5 percent hurdle, which are simple to monitor but may be just as simple to game.

What’s more, the Fed’s own incentives may support an illusion of control.

“They’re grading their own papers and they always pass,” said Kevin Dowd recently on a Cato Institute podcast. Dowd, another Fed stress test skeptic, is a professor of finance and economics at Durham University in England. “A central bank stress test can never be credible because of the incentives built in to get a pass result,” he added.

Dowd reasons that, given the Fed’s mandate to keep the financial system safe, it’s motivated to find that it is safe, similar to the way that I was incentivized to get stress testing results that supported doing my potentially mega-profitable deal.

You don’t argue when someone’s handing you a big check, but I wondered what the hell he was thinking.

I got Dowd on the phone recently and asked him what the Fed could do to improve its tests.

“First off, don’t do them,” was his response. So what model should the Fed use instead?

“I would not use any model at all. I do not believe financial risk modeling works,” he replied.

“It takes a model to beat a model,” I challenged, plagiarizing a phrase I’d learned from another professor of finance when I started in banking and which became something of a mantra of mine thereafter.

Dowd chuckled, but was unmoved. “I would always go for history over a model,” he replied, before explaining that he’d look to what capital levels were in the 19th century, when banks were private companies and less subject to government regulation.


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