Were Those Bank Stress Tests Really This Useless?

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by: Mark J. Perry

Recent Fed stress tests of the 18 largest US banks showed 17 have the capital base to withstand severe recession scenarios, including this bad boy:

Reflecting the severity of the stress scenario-which includes a peak unemployment rate of 12.1 percent, a drop in equity prices of more than 50 percent, a decline in housing prices of more than 20 percent, and a sharp market shock for the largest trading firms-projected losses at the 18 bank holding companies would total $462 billion during the nine quarters of the hypothetical stress scenario.

But a Bloomberg op-ed by MIT researcher John Gullver raises doubt as to how meaningful those tests were. They apparently make three dodgy assumptions, that a big financial shock wouldn't cause 1) a bank run by short-term creditors, 2) banks to reduce lending particularly to other banks, 3) great uncertainty as to asset values.

In other words, the tests assume some important things that happened during the Financial Crisis wouldn't happen again. I think this conclusion is fair: "Although the Dodd-Frank-mandated tests provide an important window into the resiliency of our largest banks, they do not mean that our banks could survive the severe-recession scenarios imposed by the tests."

The below chart, from Guggenheim Securities' Washington Research Group, shows what would happen to capital ratios under a severely nasty scenario compared to what happened to banks during the financial crisis. It shows - factoring in the limitations Gulliver notes - that capital buffers would hold up better now than then.

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