Fed’s Stress Tests Won’t Fix a Flawed Financial System: View

Regulators are making a valiant effort to ensure that big U.S. banks can survive the kind of shock the deepening European sovereign-debt crisis could deliver. If only the same were true for the broader U.S. financial system.

In a bid to restore crumbling confidence in the banking sector, and in compliance with the new Dodd-Frank financial legislation, the Federal Reserve is building an improved version of one of its most effective tools: stress tests designed to assess banks’ ability to withstand a market rout and a punishing recession.

Such tests played a crucial role in ending the market panic of 2009 -- an impressive feat given how lenient they actually proved to be. Back then, the tests’ worst-case scenario foresaw an average U.S. unemployment rate of 8.9 percent for 2009, falling short of the actual 9.3 percent. Nonetheless, the added clarity on the state of the financial system -- together with government capital injections -- helped bank stocks rebound more than 80 percent in the six months after the tests were announced in late February.

This time around, the Fed is subjecting the 31 largest U.S. banks to a much more daunting hypothetical future. Its stress scenario includes a 52 percent drop in the Dow Jones Industrial Average, a 21 percent decline in house prices, an unemployment rate of 13 percent and a contraction of more than 5 percent in the U.S. economy -- all consistent with the kind of disaster a disorderly sovereign default or a major bank failure in Europe could deliver. If banks fail the test, the Fed can require them to withhold dividends, end stock buybacks or take other measures to raise their capital levels.


The severity of the tests will undoubtedly create some consternation. JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon has already complained about the Fed’s meddling. That’s fine. If bank executives aren’t doing the tests on their own, they should be. And if stockholders haven’t put in enough money to absorb potential losses, they shouldn’t be taking money out through dividends and share buybacks.

The bank tests’ credibility contrasts sharply with the lack of progress in other areas where financial reform is needed. Consider money-market mutual funds, which hold some $2.6 trillion in U.S. savings and may be the country’s greatest point of vulnerability to Europe. Research by Fitch Ratings suggests the funds have more than a third of that money invested in the debt of European companies. As a result, a major European financial firm’s bankruptcy could cause funds to break their promise to return at least a dollar for each dollar invested. Even one such incident could trigger mass withdrawals, crippling the short-term lending markets on which U.S. companies depend to pay their workers and buy supplies.

The Dodd-Frank law, in its efforts to end taxpayer-funded bailouts, has actually made the U.S. more vulnerable to such a money-market disaster. Under the legislation, the U.S. Treasury can no longer guarantee money-market investments the way it did after the bankruptcy of Lehman Brothers Holdings Inc. in 2008 -- a move that stopped a run on the funds. The Securities and Exchange Commission has rightly suggested solving the problem by setting capital standards for the funds, or by requiring them to adopt a floating share price, but it hasn’t yet issued a formal proposal.

Bloomberg View columnist Jonathan Weil points out another big flaw: Dodd-Frank prevents the government from guaranteeing, as it did with the 2009 Troubled Asset Relief Program, that weak banks will get the capital they need. At the same time, regulators have yet to reach agreement with their foreign counterparts on how to take over and dismantle a large bank with international operations. As a result, if such an institution fails the stress tests and proves unable to raise its own capital, the repercussions could be much worse than they were when Lehman went down.

Even with the best of stress tests, the country’s financial system remains riddled with weaknesses more than three years after its near-collapse. Unless the obvious flaws are fixed, no legislation can credibly claim to protect taxpayers, and risking their money in government bailouts will remain the only way to avert a more painful and expensive outcome.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.