Under the supervision of Daniel Tarullo, President Barack Obama’s first appointee to the Federal Reserve Board, the Fed recently conducted a rigorous “stress test” to measure how financial institutions would fare in dire economic circumstances, including a 52% drop in the stock market, a 21% decrease in housing prices, and a 13% unemployment rate. The Fed determined that, under the hypothetical conditions, 15 of 19 major banks passed. Surprisingly, Citigroup appears to have failed the test. Nevertheless, depending on whether the economy continues to register improvement over the next year, the fact that so many financial institutions passed the stress test may constitute, in retrospect, a significant turning point in the ongoing quest to restore the nation’s financial health.
To understand what a stress test is and what purpose it serves, one must appreciate the importance of capital to a vibrant banking sector. In banking regulation, capital is what is referred to as a regulatory form of equity, meaning the banks’ assets minus its liabilities. In other words, a bank’s net worth. Banks that are well capitalized can sustain financial crises better than those that have lower capital levels. This is why, in stress testing, the Fed’s regulators want to know how banks would respond to adverse economic shocks. After all, when a bank’s capital level approaches zero, the bank is insolvent.
Stress testing also highlights the difficulty of accurately predicting the future in a complex world. Can we ever be sure what an all-out conflict with Iran would do to the world banking system? Likewise, tests can be flawed and lead to the wrong conclusions. Just several days after the Fed released its initial test results, it acknowledged it has erred in projecting Citigroup’s theoretical mortgage losses. Citigroup appears likely to continue challenge the Fed’s results.
Although stress testing may be more of an art than a science, it nevertheless highlights a constructive and positive role that the Federal Reserve can play in the nation’s economy. Nevertheless, the banking system has many challenges in the years ahead, particularly if the Europe sovereign debt crisis expands, if the housing market experiences an even bigger drop than the one modeled by the Fed, or if student loan defaults cascade. Regulators are far from infallible. But it is heartening to know that all 19 of the stress-tested banks are in much better shape than they were 2008.
Photo Credit: Chris Yunker