Latest stress tests show Fed has learned nothing about transparency

In a Wall Street Journal Heard on the Street column, the Fed is praised for the additional disclosure it is going to make involving the upcoming stress test.

These additional disclosures will be made in the context of preserving the Fed's information monopoly on all the useful, relevant data from the financial institutions.

What won't be provided is ultra transparency for each financial institution.  Disclosure of each financial institution's current asset, liability and off-balance sheet exposure details would let market participants run the tests for themselves.

Of course, there is one other  small problem with stress tests:  nobody believes the results of the Fed stress tests!

Several months prior to the banks releasing the results of their last stress tests, your humble blogger predicted the results.

Pulling out my crystal ball, I see that the stress tests show that Bank of America still needs to raise capital ...

This blog has repeatedly observed that the only analysis that market participants will believe is one that they can independently perform themselves or by hiring a third party expert.

In addition, there is one really large problem with stress tests:  after the Fed or the banks announce the results, the Fed is now explicitly on the hook for the next year for bailing out any debt or equity investor in the stress tested financial institutions.

Why?  Because the Fed is explicitly saying these financial institutions are solvent right down to their $5 trillion in derivative exposures.

Given the Fed's position and its access to better data than any other market participant, market participants will rely on the Fed's assessment.  This sets up a moral responsibility to bailout investors.

Too bad it takes a crisis to force more openness at the Federal Reserve. 

Earlier this year, the Fed conducted "stress tests" of leading financial institutions as it considered requests from them to return capital to shareholders. Unlike similar tests in spring 2009, during the height of the financial crisis, the Fed declined to make public specific test results. 

In fact, it didn't even release details on which banks' capital plans had been approved. Instead, it left that up to individual firms, leading to confusion among investors. 

And that was despite indications by some Fed governors, notably Daniel Tarullo, that greater transparency on the central bank's part could strengthen the financial system and lead to greater market discipline. 

Now, with Europe in crisis, the Fed, is coming around. In announcing stress tests for early next year on 31 financial institutions—compared with 19 tested earlier this year and in 2009—it said it would disclose test results for 19 of the firms. 

It also said it would release results of an additional test of how the six largest institutions would fare under a "hypothetical global market shock." 

Also telling is disclosure on the scenarios banks will have to use in testing their financial strength. 

While the scenarios don't represent the Fed's actual economic projections, they do give investors a sense of how bad things could get and how much things have changed.... 

Hopefully, this time, the Fed will have learned that it should strive for transparency in both good times and bad.