With Its Stress Tests, The Federal Reserve Is Looking Backwards

To this day it’s said that mark-to-market (MTM) accounting rules are what caused existential troubles for banks and investment banks back in 2008. It sounds so compelling at first glance, but only until readers stop and imagine what the outlook for financial institutions would have been without MTM. No different.

As Blackstone co-founder Stephen Schwarzman observed in his excellent memoirs, What It Takes, no amount of protest from inside Lehman Brothers about the quality of its assets could overcome the underlying reality of how distressed they were at the time. Markets speak, always. And with or without accounting rules.

It’s worth thinking about as a Federal Reserve still traumatized by 2008 foists all manner of “stress tests” on banks as a way of allegedly ensuring their health during times of trouble. The Fed’s aggressiveness implies that its rules, and the tests it’s devised as a way of divining the soundness of banks, is what keeps those banks upright. How very backwards.

To see why, imagine for a moment if there were no Fed-administered stress tests. If so, does anyone seriously think banks would be in worse shape, and that their share prices would be lower to reflect the possibility of a collapse borne of insufficient stress testing ahead of time? Hopefully the question answers itself.

If not, nothing would change if the Fed stepped back. And the reasons why are basic. The central banks claims its stress tests are a necessary look at how banks and financial institutions would weather a variety of economic calamities, but the conceit of such a belief is impressive. It implies that the Fed’s tests will somehow account for the kinds of economic calamities that await banks. They can’t. And this shouldn’t be taken as an insult of the Fed. It’s just a statement of the obvious.

As previously mentioned, the Fed is still traumatized by 2008, along with every other challenging financial period that has revealed itself over the years and decades. Which is the problem. It brings to mind the opening of Anna Karenina: “each unhappy family is unhappy in its own way.” By extension, each challenging stretch for banks is unique in its own way.

Which is a small hint that the Fed’s stress tests aren’t protecting banks as much as they’re a look backward, and an attempt to apply the problems that afflicted banks in the past to the present. What the regulators at the central bank miss is that financial institutions are already accounting for the past in the present. In other words, the past is already priced and accounted for.

What’s not priced is a future that by its very description is opaque. Think Tolstoy again. All people are different, so are families, and so are problems for banks.

The Fed is stress testing the knowns, but it’s the unknowns that invariably lurk. That’s why the really challenging stretches for banks are only obvious after the fact, and to the surprise of central bankers. In other words, if the Fed were capable of stress testing tomorrow, we wouldn’t need stress tests. And we wouldn’t because tomorrow would already be accounted for.

Which means the stress tests administered by the Fed, and the capital requirements that follow aren’t enhancing bank soundness. Looks backward rarely do.