Big banks operating in the US have just come through not one but two stress tests. The first, more formalized, was the regular post-global-financial-crisis affair that is conducted by the Federal Reserve, under its comprehensive capital analysis and review (CCAR) regime, and its associated forward-looking component, the Dodd-Frank stress testing (DFAST).
The second, more chaotic, was Covid.
The real-world test informed the hypothetical one. The Fed inserted an additional round of testing in December 2020. And it tweaked its models to take into account what it calls “the Covid event”, specifically in the areas of auto and credit card, commercial real estate and first-lien mortgages in forbearance.
That all the banks passed the Fed’s tests, despite projections of $474 billion of losses in a severely adverse scenario, tells us they look well prepared for whatever the regulator can imagine. But does the fact they passed the Covid test tell us they were prepared for that?
Policymakers would do well to bear in mind what stress tests capture, and what they don’t
For some, it might. After all, the most diversified banks have been rewarded handsomely for their exposure to booming conditions, particularly in both primary and secondary fixed income and equity market businesses. Such results often more than made up for heavier provisioning in their retail and corporate loan books.
But as Neel Kashkari, president of the Minneapolis Fed, noted in the Financial Times this week, that banks were able to do this at all was in large part due to the extraordinary measures taken by governments that had the effect of alleviating much of the risk that banks would otherwise have faced – a fact that seems to run counter to the regulatory intention to ensure that banks could handle crises without being propped up by governments.
And while the proximate cause of the 2020 economic meltdown was not a banking crisis, something that allowed banks to proclaim their role as part of the solution this time around, the scale of government intervention was at least partly a bailout of banks.
The Fed’s own reasoning behind its model tweaks seems to recognise this. Covid, it said, “caused unprecedented changes in macroeconomic and financial variables. At the same time, credit risk measures have not risen appreciably from pre-Covid event levels, due to government responses to support households and businesses.”
Bankers argue, with some justification, that to build a system resilient enough to withstand the shock of the pandemic without any external help would be in effect impossible – and attempting to do so would fatally damage the industry’s ability to fulfil its functions and be investible in normal times.
Perhaps that is right, but there is surely plenty of room for debate. Kashkari called for banks to raise $200 billion of equity when the pandemic hit, and he now wants banks to run with equity capital of closer to 20% than the 13% they typically have today.
Numbers like this will doubtless be argued over for a long time to come. Some will balk at the idea of any further ratcheting up of requirements. Others will call for extreme measures with little thought as to the economic consequences in the times between crises.
But as banks breathe a sigh of relief that they can once again splash cash on dividends and buybacks, policymakers would do well to bear in mind what stress tests capture, and what they don’t.
