Bank Stress Test Results Are Just Window Dressing

• window dressing: an adroit but superficial or actually misleading presentation of something, designed to create a favorable impression.

“the government’s effort has amounted to little more than window dressing” (Oxford Languages)

BANK STRESS TESTS – FEELING GOOD AND TALKIN’ THE TALK

The Federal Reserve recently reported the results of its annual economic stress tests for banks. The test supposedly indicates how banks can be expected “to perform under certain hypothetical economic conditions.”

The reason it is termed a stress test is because the hypothetical conditions are negative in nature…

“The 2024 stress test shows that the 31 large banks subject to the test this year have sufficient capital to absorb nearly $685 billion in losses and continue lending to households and busi- nesses under stressful conditions.” Executive Summary @ federalreserve.gov

The June 26, 2024 press release stated that the “Federal Reserve Board annual bank stress test showed that while large banks would endure greater losses than last year’s test, they are well positioned to weather a severe recession and stay above minimum capital requirements“.

This year’s test was modified to be more stringent in order to reflect the possibility of more severe liquidity problems for banks in light of numerous bank failures experienced last year, highlighted by Silicon Valley Bank (SVB). Below is how the matter was addressed by Fed Chair Jerome Powell at that time…

“So, I guess our view is that the banking system is sound and it’s resilient—it’s got strong capital [and] liquidity. We took powerful actions with [the] Treasury and the FDIC, which demonstrate that all depositors’ savings are safe and that the banking system is safe. Mar 22, 2023 

The statement was a bit premature as other banks subsequently failed. Anxiety was calmed, however, and fears were tempered. A follow-up statement by Chair Powell provided additional reassurance…

“The U.S. banking system is sound and resilient, with strong levels of capital and liquidity. (Powell, July 23, 2023)

QUESTIONS AND CONCERNS 

What if conditions are worse than those simulated in the stress tests? In financial and economic matters, it most always seems to be that way. The current stress test parameters allow for declining interest rates. The Fed may want to see rates lowered in a crisis, but wholesale dumping of worthless credit obligations would send interest rates through the roof. We saw that in 2008 with residential mortgages specifically and bonds in general. The Fed might not be able to stem the tide with purchases for their own account as they did then.

Banks are notoriously illiquid. There are no reserve requirements. The 10% fractional-reserve requirement based on bank deposits was eliminated several years ago. That’s not much, but, at least it provided a measure of (il)liquidity and a margin of solvency. It is not unrealistic to assume that some banks now, probably have loaned out more money than they have in total deposits.

The deposit was eliminated for two reasons: 1) to support efforts to flood the economy with money in response to the forced Covid shutdown and resumption of economic activity afterwards and 2) most banks were probably in danger of violating the existing 10% reserve requirement; remove the requirement and the problem goes away – for a little while, maybe. (see more about fractional-reserve banking)

The banks aren’t satisfied, though. They want less stringent requirements.

CONCLUSION

The extent and duration of pending financial and economic crises will be worse than any previous ones. The events themselves and their negative effects will confirm that bank stress tests and their results are inadequate, unreliable, and virtually worthless.