Fed Should Stop the Stress Test Guessing Game

To the surprise of financial markets, this week the U.S. subsidiaries of the foreign banks Banco Santander and Deutsche Bank failed the Federal Reserve's annual stress tests. The stress tests are an important way to measure banks' preparedness to weather a variety of volatile financial scenarios. But there is a big problem with the Fed's current testing regime. Because the tests lack transparency, banks can wind up failing them for fairly minor reasons — not because they face a liquidity shortfall.

With the aim of improving financial stability by increasing bank capital requirements, the Fed stress tests have encouraged the largest U.S. banks to increase their capital. The capital of the 50 largest banks totaled $1.2 trillion at the end of the third quarter of 2014, up considerably from $506 billion in early 2009 before the Fed's first stress tests were first implemented, as The Wall Street Journal reports.

But in an effort to keep the tests unpredictable so that banks can't find ways to work around them, the Fed has erred too much on the side of opacity. In past years the Fed has provided more emphasis toward minimum capital requirements for European bond holdings. More recently, the regulatory focus has been placed on capital requirements for leveraged loans.

Recent stress tests have also placed an increasing emphasis on "qualitative measures," including how banks identify and mitigate risks. This is a highly subjective matter, and the Fed offers little guidance on it for banks to follow.

Deutsche and Santander failed the tests not because of liquidity shortfalls like those experienced in 2008, which the stress tests were originally designed to root out, but because of confusion around these qualitative issues.

Several fixes for the Fed's stress tests could greatly improve their efficacy in fostering financial stability and protecting the solvency of banks.

First, the Fed should drastically increase the transparency of stress-test requirements. In the present regulatory framework, no bank actively wants to fail a stress test and face the consequences of losing its ability to issue increased dividends or share buybacks. These are important tools that companies use to boost their stock prices by signaling underlying financial strength.

No bank chief executive would rationally choose to forgo such tools. But because of the regulatory uncertainty created by stress tests, banks may choose to reallocate assets in ways that may not help them withstand the Fed's enigmatic financial scenarios.

If the Fed created a specific list of capital requirements and scenarios comprising the stress tests and gave them to banks in advance, banks like JPMorgan Chase would be less likely to have to rewrite or adjust their capital plans before receiving the Fed's green light.

With more transparency, banks would fail stress tests only if they truly had a potential liquidity problem that could create systemic risk. Stress tests would then become a much more effective indicator and deterrent of bank insolvency.

Banks shouldn't have to waste time playing a guessing game as to what, exactly, stress test requirements are. This guessing game comes at a high cost for banks, creating a drag on the overall financial system.

For instance, JPMorgan has a dedicated group of 500 employees who work exclusively on stress test compliance. In recent years, Citigroup has reportedly added 10,000 employees to ensure compliance with Dodd-Frank regulations and preparation for the annual stress tests. With simpler rules requiring smaller compliance departments, many of these employees could reassigned to more productive work.

Federal Reserve Governor Daniel Tarullo said last year that the Fed is opposed to providing more stress test transparency to banks because "we certainly do not want them to construct their portfolios in an effort to game the model" in order to meet specific test requirements. In order to address this issue, the Fed could conduct simpler, more transparent stress tests more frequently — perhaps on a quarterly basis.

Right now, since stress tests only happen once a year, banks can "game" the stress tests by accumulating the right positions necessary to meet the requirements when the tests roll around and quickly revert back to smaller capital cushions. A higher frequency of tests throughout the year would easily prevent this moral hazard.

A higher frequency of stress tests would also help identify bank capital deficiency problems faster. It would also reduce the impact of stress tests on financial market volatility, since capital deficiencies would have less time to fester.

These reforms would greatly help reduce regulatory uncertainty, improve financial stability and potentially prevent another global financial crisis.

Jon Hartley is an economics contributor for Forbes and Economics21.org, the economics portal of the Manhattan Institute. He is also a co-founder of Real Time Macroeconomics LLC, a financial technology firm.