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Updated on Thursday, March 12, 2015
Every year, the Federal Reserve carries out a stress test on all banks that have more than $50 billion of assets. Banks have to pass both a quantitative and a qualitative exam. In the quantitative exam, the Fed wants to ensure that the banks would still have enough capital to survive after a dramatic event, non unlike the crisis in 2008. In the qualitative exam, the Fed looks at the culture and the process around managing capital and risk at banks. The results of the test have a huge impact on the bank, its management and its shareholders. For any bank failing the stress test, they would be limited in their ability to pay dividends to shareholders, and the management would be at risk of being terminated. For example, Citi’s CEO Michael Corbat was expected to lose his job if his bank failed again this year.
This week, the Fed released the results of its survey of the 31 banks representing nearly 80% of the banking sector. And two European banks failed the qualitative portion of the review: Santander and Deutsche Bank. All other banks passed. Mike Corbat will be able to celebrate another year of employment, and Citi shareholders will finally see an increase in their dividends.
For the European banks, the results will likely be frustrating. Banks have long argued that the calculations for the quantitative portion can be arbitrary. But the qualitative portion is even more difficult. Understanding how the Fed judges this portion can be difficult to understand. How can you subjectively understand if a bank’s “internal capital planning process appropriately captures the specific risks and vulnerabilities faced by the firm under stress.”
The reaction of most banks is to throw bodies and money at the problem. Deutsche Bank has indicated that 1,800 employees will be fully dedicated to improving and enhancing the risk and capital management process. Citi, in response to previous failures, has greatly expanded its stress testing workforce. The credit card risk unit alone has over 250 employees working full time on stress testing requirements.
Should I Be Worried About Santander? And Should I Feel Better About Citi?
During the financial crisis of 2008, it became clear that large, systemically important institutions had taken far too much risk, and they had insufficient capital and liquidity to weather the storm. As a response, regulators and lawmakers have been focusing on increasing the amount of capital and liquidity that banks hold. But the absolute increase in capital was not deemed sufficient by the Fed. They wanted large banks to go through a stress test to see if they could survive a repeat of the 2008 financial crisis, but this time without taking money from the government.
When the results of the first stress test were released, investors, lawmakers and customers applauded the move. However, the entire stress test process has taken on a life of its own. Banks are studying the test, and industries of consultants have been built helping banks prepare for and pass the tests.
As you can imagine, an almost terrifying number of assumptions have to be made in this exercise. For example, if house prices decline across the country, the scenario needs to answer questions like:
- How many people would pull their deposits out of the bank in a panic?
- How many people would stop paying their bills?
- How much liquidity would leave the interbank market?
Each one of these questions is a mixtures of educated guessing and complete conjecture. No one would have predicted that the a subprime loan in California would lead to the collapse of a German bank and a London derivatives desk. If we knew the risk in advance, we would plan for it. These big banking crises happen regularly because we do not understand the severity and interconnectedness of the risks we are taking.
However, the stress test exercise assumes there is a right answer. We can calculate how much would be lost in a particular scenario, and we can ensure banks have the right amount of capital to keep the system safe.
Even the Fed recognizes that trying to calculate the right answer to an exact decimal point is a fool’s errand, which is why they have a qualitative review. They want to see how senior management talks about, manages and controls risk. However, even this review has become formulaic. Banks are guessing (appropriately) that throwing more people and money at the exercise will be a signal of seriousness. So, they build huge departments of people who think about capital and risk.
There is a real risk that the stress testing exercise turns into a meaningless financial forecast coupled with a dramatic increase in risk management headcount. More does not always mean better. In fact, it can have an opposite effect. Having too many people makes it more difficult to see the whole picture, creates office politics and increases the potential for errors.
We should not run from Santander, just because they failed. And we should not celebrate Citi, just because they passed. Banks that are larger than $50 billion will, by definition, have risks that are undetected or underestimated. The Federal Reserve’s rigorous review of models built by new hires and consultants will not be enough to bring comfort.