Big banks, stress tests, and a global pandemic

In 2008, the U.S. economy was devastated by the collapse of many of the nation’s largest banks and required a massive bailout funded by American taxpayers. Today, as COVID-19 continues to create enormous uncertainty about the path of the economy, the public’s ability to assess the true condition of the nation’s largest banks remains limited.

The Minneapolis Fed and leading experts on banking and regulatory policy came together recently for a virtual conference to discuss ways to empower the public to make their own assessments of the strength of large banks.

In his opening remarks, Minneapolis Fed President Neel Kashkari emphasized the importance of transparency and giving the public the ability to run their own stress tests. Pointing to the Minneapolis Fed’s newly launched stress test tool, Kashkari said the tool is designed to reduce uncertainty by helping people “render their own judgments” about the condition of large banks.

Echoing the message of transparency in his keynote address, University of Oxford professor Sir John Vickers recounted his work at the Bank of England two decades ago to make monetary policy models available to the public. Vickers explained that while there were concerns about making the models public, he believes the models are much improved thanks to the public’s constructive criticism.

“That [experience] inclines me to welcome the steps that you’re taking … [of] democratizing the stress test tool,” said Vickers.

While stress tests are primarily designed to measure bank resiliency, Vickers contends that transparency around the tests themselves can both hold regulators accountable and ensure that the tests produce rigorous results. “If you don’t have transparency,” said Vickers, “these tests can do more harm than good. I think they have contributed in some countries to a questionable sense of security.”

In a panel moderated by Ann Saphir of Reuters, several experts reflected on the stress test tool, the state of testing, and what transparency means in practice. A key piece of feedback from the panel discussion was the need to make a clear case about why the Minneapolis Fed’s COVID-19 stress test tool and related efforts at transparency are important. There were also calls to further clarify the tool’s primary audience.

Stephen Cecchetti, economics professor at Brandeis University, proposed a “reverse stress test” that gives users the ability to toggle accounting valuations. Cecchetti said this feature can help users understand “what configuration would lead to capital levels below a specified threshold.”

Beverly Hirtle, director of research at the Federal Reserve Bank of New York, pointed out that the banking industry is more than the sum of its parts. “[It] would be interesting to explore … the linkages within the banking system,” said Hirtle. In the Minneapolis Fed’s stress test tool, “the banking industry is simply the sum of what you get for the individual banks, and there’s no feedback among the banks or between the banks and the economy in the scenario.”

Stress tests are often used to determine appropriate bank capital levels during normal, nonrecessionary times. As the economy is currently in a pandemic-induced recession, the way stress tests are being used now is very similar to the way they were used in 2009 at the height of the Great Recession. “[The Minneapolis Fed’s] tool distinguishes COVID-specific scenarios,” said Adi Sunderam, professor of business administration at Harvard Business School. “It is quite important that we make clear that stress tests are a dynamic tool, and that just because [a bank] passed a stress test last year, that has nothing to do with the current scenario and does not mean we’re going to just leave the banks alone.”

Panelists called for further specification about the audience for which the tool is intended and what they should take away from it. Deborah Lucas, finance professor at MIT Sloan School of Management, clarified that this tool is not truly for the general public. “There are three main audiences for which this will be useful: purveyors of information about banks, such as bank analysts and journalists; educators; and regulators and researchers,” said Lucas.

While transparency and access to this information is important, Lisa Donner, executive director of Americans for Financial Reform, a consumer advocacy group, emphasized that there are large knowledge and power gaps between financial institutions and the general public. “The policy choices and policy levers that do so much to shape the economic reality we experience are often largely invisible to most people,” said Donner.

Ron Feldman, Minneapolis Fed first vice president, concluded the conference by committing to make further improvements. “We are invested in the work that you’ve seen,” said Feldman. “One reason we brought together a group of really smart, distinguished people was to get their take on what we should do.”

Ultimately, there are more inputs and scenarios for which any one regulatory testing mechanism can account. The primary goal of the Minneapolis Fed’s COVID-19 stress test tool is to give the public a way to judge the health of the nation’s largest banks, but there is more to consider.

“We’ve largely been thinking about how to make this tool more like the official analysis [than not],” said Feldman. “The feedback we got here was that we are a bit liberated from that.”