So all’s well. No more financial meltdowns. No more taxpayer bailouts of bonus-hunting, risk-taking bankers. The Federal Reserve Board’s regulators have decided that all 31 of the largest U.S. banks, including seven that are foreign-owned, would survive a severe recession with sufficient capital to continue lending and remain in business without a taxpayer bailout. The tests, devised by the Fed after the near-collapse of the financial system following the demise of Lehman Brothers in 2008, assume that the unemployment rate rises to 10%, share prices drop by almost 60%, house prices plummet 25%, loan losses clock in at $366 billion, and interest rates rise sharply. If that’s not stress, it is difficult to imagine what is.
It is also comforting to know that the plans of most banks to reward shareholders with dividends and share-buybacks were approved, although in some cases only after those plans were adjusted to meet the Fed’s requirements, and planning and risk measurement techniques were upgraded. This second set of more qualitative tests, the Comprehensive Capital Analysis and Review (CCAR), is the foot on the neck of bank CEOs, whose jobs depend on their ability to reward shareholders and keep them happy if possible and passive at worst. Only the U.S. units of Deutsche Bank and Santander had the pay-out plans of their American operating units flatly rejected because of deficiencies in their ability to model losses and risk.
It might seem churlish, in the face of such good news, to raise a few questions, but churlish is what economists do best, so here goes.
These stress tests are designed to determine whether the more robust capital base of these banks will enable them to survive a crisis with the contours of the last one -- deeper in some ways, but otherwise not very different. And if we know one thing it is that the next crisis will be different from the last one. Since we can neither predict the timing of the next crisis, nor its size, nor its shape, we can only say that if the next one is more or less like the last one, we are safer than we were before the stress tests were invented and applied.
Add to that the unpleasant fact that it is uncertain that bankers have replaced hubris with humility, greed with ethical behaviour. No less an observer than Fed chair Janet Yellen is unhappy with bankers’ relaxed attitude towards the law and ethical standards, both of which, she says, “bankers at large institutions” have ignored, “sometimes brazenly … [raising] legitimate questions of whether there may be pervasive shortcomings in the values of large financial firms that might undermine their safety and soundness”. Manipulating currency and interest rate markets, money laundering, and tax evasion by large institutions continue to rear their ugly heads.
The Fed is so unhappy with bankers’ standards and attitudes that it has transferred supervision of the activities of big banks and other financial firms deemed “systemically important” to a new, Washington-based Large Institution Supervision Coordinating Committee. This is a blow to the New York Federal Reserve Bank, which Fed regulators deem to have had too cosy a relationship with bank executives. Regulating “ethics” and “culture”, rather than mere obedience to the law, is uncharted territory, its effectiveness uncertain even after a 220-mile southward move of the regulatory apparatus, and to Washington, D.C. of all places. So, too, is the number of so-called Matters Requiring Attention a bank may accumulate before being penalised.
Another worry is that banks remain heavily dependent on short-term capital, the sort that “runs” at the first hint of trouble. To add to the problem, many banks have yet to come up with satisfactory “living wills”, the term used for plans to dissolve themselves and disappear without causing inordinate harm to the financial system as a whole.
Then there is the problem created by the provision of the Dodd-Frank law that limits the ability of the Fed to act as lender-of-last-resort when a bank hits the rocks. It now must seek the permission of the Treasury before it can launch its life boats, and cannot bail out only a single, selected institution, as it did in the case of AIG in the recent crisis. Not knowing whether the Treasury will go along with a Fed proposal to fulfil the role of lender of last resort just might prompt worried investors and depositors to take their money and run.