Bank Stress Tests Are A Dog & Pony Show

By Paul-Martin Foss

In the aftermath of the financial crisis, central banks around the world began to subject their banking systems to “stress tests” – creating hypothetical worst-case scenarios and analyzing whether or not banks were capable of remaining in operation under those hypothetical conditions. The central banks would then publicize the results of the stress tests and announce which banks had passed and which still needed to raise capital. As Matthew Klein at the Financial Times Alphaville blog pointed out, as late as October 2014 the European Central Bank conducted stress tests of Greece’s four largest banks and declared three of them adequately capitalized, with the fourth one not too far off. Yet as the Greek crisis has demonstrated, passing that stress test was absolutely meaningless, as all Greek banks are now close to failure. So what good are bank stress tests?

Klein points out that one of the likely assumptions in these stress tests is that under adverse economic conditions, banks will still have access to funding from the central bank. Remove that lifeline and the likelihood of a bank failing increases exponentially. That of course leads one to wonder, what kind of assumptions does the US Federal Reserve make when it undertakes its bank stress tests?

Not surprisingly, the “most transparent central bank in the world” just a couple of weeks ago announced that its stress test models would not be made public. While the Fed’s explanation was that publishing its models would allow banks to game the system, one has to wonder if perhaps the models are not nearly as robust and realistic as they should be. If we now know that the ECB’s stress tests of Greek banks were absolutely worthless, why then should we trust the Federal Reserve’s stress tests any more?

We can only conclude that the stress tests have two purposes: 1.) to reassure the public that the banking system is safe and sound so that depositors will continue to deposit their money; and 2.) to punish any banks who fall afoul of the Fed for any reason by giving them a negative assessment after a stress test, thus tarnishing their reputation in the public eye. The former is probably more important than the latter, as the overall health of the banking system depends on the existence of deposits. Without money deposited in banks, banks cannot lend and make money. Thus, ensuring that depositors don’t flee the system is one of the primary aims of central banks and banking regulators.

Bank stress tests then are really nothing more than a dog and pony show, especially if the stress test models aren’t being made public so that their relevance (or lack thereof) can be ascertained. Rather than serving as any sort of benchmark or indicator of the health and strength of the banking system, they are yet another tool that the Federal Reserve uses to “manage expectations” – to manipulate people into believing that banks are safer and sounder than they actually are. The citizenry will faithfully continue to deposit their money into bank accounts, not once doing due diligence to see just how sound their banks actually are. And the whole rotten system will continue to lurch from crisis to crisis until its final collapse.


The above article originally appeared at The Carl Menger Center

---