(Bloomberg Opinion) -- Every year, the Federal Reserve conducts a round of stress tests purported to ensure that the banking system can weather a financial crisis. With the latest results coming next month, people are wondering: Will the exercise become less stressful amid President Donald Trump’s deregulatory drive?
Judging from the past several years’ results, it already has.
The stress tests are far from ideal to begin with: They can’t replicate the chaos of a true crisis, and the bar for passing is pretty low. That said, they’re an improvement over what regulators had before the 2008 crisis. They force bank executives to think about worst-case scenarios, and to maintain at least a modicum of equity capital -- the bedrock funding that allows the financial system and individual companies to absorb losses and keep operating through economic downturns.
Now, observers worry that the Fed is weakening the tests further. It has given banks more information about the models it uses to estimate losses -- tantamount to showing students the exam before they take it. It will share the results with banks before they submit plans for dividends and stock buybacks, allowing them to avoid the embarrassment of having those plans publicly rejected. And it has eliminated the “qualitative objection,” which it previously used to flunk banks that couldn’t demonstrate an adequate grasp of the risks they faced.
The changes certainly facilitate a softer approach. Yet a look at previous results suggests that regulators have already been easing up without their help. Consider, for example, the losses (net of income) that the Fed’s “severely adverse” scenarios have generated: For all banks participating in the 2017 and 2018 tests, they averaged just 0.8% of assets, compared with 1.5% in the four previous years.
The picture is similar for the six largest banks, which the Fed subjects to an added global market shock and counterparty default. To be fair to Trump, the easing appears to have started under the Barack Obama administration in 2016:
Proponents of stress testing argue that it’s better than just setting higher capital requirements in the first place. The tests can adapt to evolving risks and markets, and can be ratcheted up in good times to ensure that banks have more resources to weather bad times. Yet experience suggests that they’re all too susceptible to human nature. As the memory of the last crisis fades, the will to be vigilant dissipates with it.
To contact the editor responsible for this story: James Greiff at jgreiff@bloomberg.net
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Mark Whitehouse writes editorials on global economics and finance for Bloomberg Opinion. He covered economics for the Wall Street Journal and served as deputy bureau chief in London. He was founding managing editor of Vedomosti, a Russian-language business daily.
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