Stress Tests Contribute to Financial Instability

The FDR Framework is a model that cannot be ignored because of its predictive abilities.

As discussed previously (see here and here), the FDR Framework predicts that financial regulators through their monopoly on all useful, relevant information on financial institutions and structured finance products both contribute to and perpetuate financial instability.

An example of how financial regulators contribute to financial instability is the stress tests.  The stated goal of these tests is to restore and enhance confidence in the market.

The FDR Framework predicts that this will not happen because the financial market participants do not have access to the current asset and liability level data that the participants need to run stress tests on their own and confirm the findings of the regulators.

So what happened with the latest round of stress tests in the US?

According to a column in the Wall Street Journal,

Beyond confirming that BofA is trailing the big-bank pack, the meaning of the Fed's decision wasn't exactly clear, however. That's largely because of the paucity of information the Fed released about the 19 financial institutions that took part in the latest stress tests. Instead, investors are being left to wonder what part of BofA's capital plan may have caused unease. 

And although Bank of America in its statement pointed to progress made in building capital, the Fed's rejection "highlights again how its capital levels are weaker than others," noted Evercore Partners analyst Andrew Marquardt. He estimated BofA had a Tier 1 ratio of 5.5% to 6%, based on future Basel III capital rules, compared with an average for big banks of closer to 7%. 

The Fed didn't even release details about which banks' capital plans had been approved or rejected, leaving that up to individual institutions. That has even led to questions around other firms.  

... The Fed's stress tests should give markets greater confidence. In this instance, they have generated additional uncertainty.

According to a Breakingview column,

... It all makes it look as though the Fed is on top of keeping banks’ balance sheets healthy. But the U.S. central bank should still reveal more about its rationale. 

The basics are straightforward. 

... The bank is not there yet. And the Fed deserves credit for reminding the bank’s executives and directors of that. But it’s not clear whether the Fed is worried about BofA’s core earnings falling short or about potential losses being higher than the bank projected, to pick a couple of possible concerns. 

Of course the Fed may simply be making a show of saying “no” to somebody. 

...That’s not nothing, but for a company with Tier 1 common equity of $125 billion, it’s surely not enough to have a big impact on its soundness. Greater transparency from the Fed would help clear up the reasoning.

As predicted by the FDR Framework, the stress tests failed to enhance confidence in the market.  In fact, they created greater uncertainty.