Stress Tests and Too Big To Fail

The global bank regulatory community is busily engaged in performing stress tests on the largest financial institutions in each country.

• In the US, the stated goal of the tests is to answer the question which of the 19 too big to fail banks has adequate capital and therefore can begin paying dividends again.  

• In the European Union, the stated goal of the tests is to restore confidence in the banking system by answering the question which banks need additional capital to either return to or remain solvent and what is the source of this capital.

• In the UK, the stated goal of the tests is to provide more transparency into the health of the banks.

In the absence of disclosure of current asset-level data, the greatest impact of each stress test is to reinforce the concept of too big to fail banks.

As soon as they are announced, the markets already have a fairly accurate guess at what the results of the stress test will be.

Is there anyone who doubts that JP Morgan will be allowed to start paying dividends after the latest US stress test?  [With the restoration of bank dividend payments in the US, capital adequacy standards will be set on a global basis.  Since a bank cannot be seen as having adequate capital for paying dividends and not be adequately capitalized for regulatory purposes.]

Stress tests are championed by US Treasury Secretary Tim Geithner.  He likes to point to the release of the US bank stress tests in 2009 as a turning point in the financial crisis.  What Mr. Geithner conveniently leaves out of the story was that as part of releasing the stress tests he cemented in the idea of too big to fail by pledging the full faith and credit of the US to keep the banks subject to the stress test solvent.

Markets reacted positively to the pledge and not to the stress test.  The pledge, like the FDIC guarantee of bank deposits under $250,000, eliminated the need for the market to do any research into the solvency of the TBTF institutions.

There are a number of problems with the stress test and government guarantee approach.

Ireland discovered one.  The problem the Irish discovered is the size of the hole in the banking system might dwarf a country's ability to fill it and remain solvent.  When this happens, a country's too big to fail banks become too big to save.

Spain discovered another.  The problem the Spanish discovered is that trying to manage perception of the size of the hole in the banking system creates greater financial instability [see Moody's recent downgrade of Spain].

How did we get to this position where regulators are trying to use stress tests to restore confidence in the financial system while substantially weakening their sovereign's ability to handle future crisis?

How did we get to a position where regulators are substituting their ability for the market's, including the bank's competitors and other market participants, at analyzing each bank's current asset-level data?

One part history.  One part the failure to adhere to the FDR Framework.

In discussing the FDR Framework, this blog has highlighted how the absence of 21st century information technology in the 1930s required the government, with its exposure through deposit insurance, to take on the monitoring, analysis and discipline role that the financial markets would otherwise perform.

For US regulators operating in a 1930s world, performing stress tests and announcing the results would have been sensible.  This is what they effectively did when they closed all the banks and selectively reopened some.

The regulators had to do this because they did not have the alternative of financial institutions disclosing all the useful, relevant information in an appropriate, timely manner to market participants.

For regulators operating in the 21st century, performing stress tests and announcing the results is not a requirement or necessity.  They have the option of disclosing all useful, relevant information in an appropriate, timely manner to market participants.

As predicted by the FDR Framework, by not disclosing all the useful, relevant information they have access to, regulators have become an obstacle to markets functioning properly.  They are the gatekeepers in maintaining information asymmetry between the current asset-level data on financial institution balance sheets and the markets.

With the stress tests, the regulators are trying to determine is there a middle ground between current financial reporting and the disclosure of all useful, relevant information in an appropriate, timely manner.

As regular readers of this blog know, there is no middle ground that does not violate the FDR Framework.  As regular readers of this blog know, violating the FDR Framework not only does not promote properly functioning markets, but it contributes to their instability.

We know that current financial reporting is inadequate because the interbank market froze during the financial crisis.  According to the Financial Crisis Inquiry Commission Report, banks did not know the exposure of the other banks to toxic securities and would not lend because of repayment concerns related to the other bank's solvency.

We know that partial reporting using stress tests also is inadequate and contributes to the too big to fail problem.  How can investors be asked to accept the risk of loss when a) they do not have access to all the useful, relevant information in an appropriate, timely manner on which to make an investment decision and b) the government is saying that that the financial institution they invested in passed a stress test?

In short, the too big to fail problem was created by regulators and their failure to adhere to the FDR Framework.  The solution is to adhere to the FDR Framework and provide investors with all the useful, relevant information in an appropriate, timely manner.