Larry Summers Calls Fed Bank Stress Test Results ‘Absurd'

(Bloomberg) -- Former Treasury Secretary Lawrence Summers called the results of the most recent Federal Reserve stress test of the largest banks “comically absurd,” and called on regulators to boost capital at financial institutions.

Summers made the comments after a presentation at the Federal Reserve Bank of Boston on the persistence of low interest rates in global economies, a phenomenon which he explained as excess savings pursuing a shortage of investments. That trend has been partially mitigated by fiscal programs, he said, such as Social Security and Medicare in the U.S., which reduce to some extent the propensity to save.

Larry Summers Calls Fed Bank Stress Test Results ‘Absurd'

“If we are likely to live in a world of systematically lower interest rates, systematically more higher asset price multiples than we have in the past,” then the case “for prudential regulation and for high levels of capital requirements in banks and more financial institutions is greatly increased,” Summers said.

Continually low interest rates, a feature of the nine-year-old U.S. expansion where the policy rate is only 1.75 percent to 2 percent currently, can produce asset bubbles.

Crisis Response

Following the 2008-09 financial crisis, Congress and regulators instituted a number of reforms to strengthen the financial system. One is the stress test where the capital of the largest, systemically important banks is tested against severely adverse economic scenarios designed by the Fed.

In the most recent stress test, the worst scenario described “a severe global recession” with 10 percent U.S. unemployment, plunging house prices, and a 65 percent fall in stock prices.

“The nation’s largest bank holding companies are strongly capitalized and would be able to lend to households and businesses during a severe global recession,” the Fed said in a June 28 press release.

The Fed asserted that if every bank continued to pay out capital in the form of dividends and share buybacks despite the severe scenario, “that none would have any capital deficiency.”

‘Comically Absurd’

“That, I would suggest, is a comically absurd conclusion that is belied by the most elementary analysis of the beta of those major financial institutions,” Summers said. “And the fact that that assertion continues to be made has to undercut whatever credibility one would would otherwise attach to the very substantial efforts that have been made to strengthen financial regulation.”

Summers’s criticism follows similar calls by officials such as Cleveland Fed President Loretta Mester, Boston Fed President Eric Rosengren, Kansas City Fed President Esther George and Fed Governor Lael Brainard to use the current period of strong growth and rising asset prices to ask banks to build up capital beyond the stress test requirements.

“If cyclical pressures continue to build and financial vulnerabilities broaden, it may become appropriate to ask the largest banking organizations to build a countercyclical buffer of capital to maintain an adequate degree of resilience against stress,” Brainard said.

The Fed passed the largest U.S. banks in this year’s stress test, some with conditions and adjustments to their payout and buyback plans. Deutsche Bank AG in June failed the test of its combined U.S. business; the Fed faulted the firm’s capital-planning practices.

Federal Reserve spokesman Eric Kollig declined to comment.

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