As reported at the Financial Times, US banks are being asked by the Federal Reserve to run a comprehensive series of stress tests to ensure they have enough liquidity to withstand various types of financial shock. The Fed regulators are asking for scenario analysis and testing to get an idea of how the banks would perform if there was a sudden and sharp downturn in the markets, or if an individual bank had to endure a major liquidity shortage, such as the one that brought down Bear Stearns (BSC).
The tests are simulating mild to catastrophic disruptions, and appear to be focusing on the balances held for the various prime brokerage businesses that lend money to hedge funds. A few hedge funds have blown-up as a result of the recent credit meltdown. It is unclear if these failures were simply a warning sign of something bigger that is worrying the Fed, or just one of many areas in need of scrutiny.
While it is unknown if and how the Fed will use the specific data, the results could provide the information they need to implement new regulatory requirements if as proposed by policymakers they eventually take over some of the responsibility currently given to the SEC and other regulators.
New requirements for regulatory capital are always met with mixed emotions. On the one hand, diligent and conservative risk management can provide confidence to both the markets and investors that a company can remain solvent, even in tough times. On the other hand, stricter regulation is usually followed by higher levels of regulatory capital that must be set aside, thereby reducing the banks ability to deploy its capital in the most profitable manner. The Fed and SEC recently identified the monitoring of liquidity as something they want to cooperate on with the investment banks. This current move appears to be one of the initial steps.