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Banks are acing their 'stress tests' — but that's not necessarily a good thing

The Federal Reserve calculates how a bank would fare in a “severely adverse” economic climate in which unemployment climbed to 10 percent and the market dropped by 50 percent.
U.S. flags in front of the New York Stock Exchange (NYSE) on a rainy day on Wall Street in New York on May 23, 2019.Johannes Eisele / AFP - Getty Images file

Regulators have made it easier for banks to pass their so-called stress tests. While this could be good for investors, some industry observers worry that it opens the door to another financial crisis.

After the market closes for the week, the Federal Reserve will release the first half of the bank stress test results, which are designed to see how banks would fare in the event of a severe economic downturn.

Banks are generally expected to pass, which is likely to raise bank stocks higher and add momentum to the new highs the market has hit. “For banks that no longer have to do the tests every year, there should be some expense savings. The test this year should also be a bit easier, so you might see increases in capital return asks,” said Eric Compton, an analyst at Morningstar. “Overall, there still seems to be a bit of extra capital to release, which should improve performance a bit.”

Under President Donald Trump's appointee Randal Quarles, the Federal Reserve has given some banks more time between tests, and has given them more information about the modeling to calculate how a bank would fare in a “severely adverse” economic climate in which unemployment climbed to 10 percent and the market dropped by 50 percent.

Experts said some changes to the parameters of the stress tests, which the financial industry has complained about since they were implemented in the wake of the financial crisis, were warranted. And starting next year, the Fed will add an additional element that could require banks to hold more in reserves based on hypothetical risk-modeling scenarios.

Banking analyst Bert Ely said this new requirement could create market distortion. “The Fed may unleash unintended consequences,” he told NBC News. “The underlying problem of all one-size-must-fit-all banking regulations [is that] they fit none very well. The Fed staff is trying to adapt to that problem through its often fuzzy forecasts of what the future might hold,” he said.

Banking experts are in agreement that the problem is no one can predict the future — but they disagree about how to measure and mitigate that risk in today’s economy. “The concern should be in how well and how aggressively the big banks are responding to changes in the risk environment,” Ely said.

“The issues that created the problem 10 years ago — it’s a rather different world today,” said Charles Elson, director of the Weinberg Center for Corporate Governance at the University of Delaware. “Changing the stress test doesn’t mean we’re heading into a financial crisis,” he pointed out.

“The problem in the financial crisis was banks did not have enough capital when loans started going bad in a hurry,” said Greg McBride, chief financial analyst at Today, that is not the case, he said. Banks are on surer footing than they were before the crisis, and are better capitalized than their foreign competitors. “The changes to the scenarios really just amount to all of a tweaking. It does not take us back to the Wild, Wild West of 2007,” McBride said. “There’s sort of the knee-jerk reaction after a crisis to institute standards that are beyond what is needed, and then over time the pendulum settles in the middle.”

But some voiced concern that relaxing stress test requirements could wind up masking risk in an as-yet-unknown aspect of the banking business. “Exempting the smaller banks made sense, but it’s crucial that the regulators continue to demand that the big banks prepare themselves for bad times and unpleasant surprises — and stress tests are perhaps the best way to accomplish that goal,” said David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution.

In particular, dropping the requirement that the banks pass a qualitative test of their internal data analytics and practices could leave blind spots. “I do worry about the decision to delete the qualitative assessment,” said Karen Shaw Petrou, managing partner of consulting firm Federal Financial Analytics. “We’ve learned too many times the hard way that models are based on retrospective assumptions,” she said — assumptions that can be exploited by poor management or the pursuit of riskier returns.

“The stress tests, while undoubtedly a hassle for the banks, play an extremely important role in reducing the chances that we suffer a repeat of the global financial crisis,” Wessel said.