The fact that
Many banks — indeed, most of the best financial institutions — perform stress testing periodically, as they should. The strongest institutions run hundreds, if not thousands, of scenarios. (Banks such as JPMorganChase
The government is not wrong to emphasize the importance of stress testing. But there are
Second, as has been noted often, the test has been conducted with considerable secrecy and without meaningful private- or public-sector debate. Yes, the government has many talented economists and other experts designing the test, but even the best team is not perfect. A more open process would be beneficial, whether or not outside feedback is ultimately incorporated.
Third, the government's heavy reliance on its own test can create a false sense of security. Policymakers, market participants, and the public — and at times even some institutions themselves — may assume that passing the government stress test means all is right with the world and that the institution is fundamentally safe or has fulfilled its stress-testing responsibilities. Nothing could be further from the truth. Passing the test simply means a bank met the assumptions of a single, government-designed scenario, not that it is prepared for the far more varied and evolving risks that define real-world banking.
Fourth, a one-size-fits-all stress test might actually increase risk by encouraging institutions to assess threats in more or less the same way, using similar measures and approaches. This uniformity can lead institutions to move together, concentrating risk and creating system-wide vulnerabilities rather than resilience. In addition, a standardized approach invites banks to tailor their portfolios and models to the test itself rather than to underlying economic reality.
Federal Reserve Governor Michael Barr warned that subjecting the stress testing models to the notice and comment process could lead them to "ossify."
Whether or not the government continues to conduct its own stress test, supervisors should insist that every institution of meaningful size and/or those whose activities present potential systemic risk perform periodic stress tests on their own, separate from any government-run process. These tests should be rigorous and involve not only the major risk and compliance personnel of the bank but also include key business leaders, senior management and, from time to time, the board of directors.
Perhaps of most importance, every bank's stress test should take tail risks seriously. As one of America's great bankers of a previous generation used to say, "It is the lightning bolt that you don't see that kills you." In my experience as a regulator, banker, and advisor to banks, I have repeatedly found that we spend far too much time focusing on the center or near center of the risk distribution curve. Yet the risks that truly matter typically reside in the tails. Keeping on top of the less-probable risks — the ones that can put an institution out of business or otherwise cause severe business disruption — is of greater benefit than concentrating on the more-likely risks that may move the balance sheet but will not turn the institution upside down.
Indeed, as part of any stress-testing exercise, considerable thought should be given not only to identifying tail risks that are more likely than commonly assumed but also to determining how best to manage those risks should they materialize. In addition, institutions should think carefully about how to respond when an unanticipated tail risk begins to reveal itself. In my experience, tail risks rarely appear without warning, like an exploding device in a James Bond thriller; rather, they tend to "fatten out" over time, generally with enough advance signal that one can minimize the potentially dire results by acting quickly and decisively.
In sum, stress testing is a critical component of sound banking. But it is not a one-size-fits-all exercise. Institutions should be required to undertake it seriously from time to time. But the more the private sector embraces this discipline with its own vigor free from bureaucratic routine the better.
