Federal Reserve Stress Tests Make Us All Muppets

March 19 (Bloomberg) -- There was disheartening news last week regarding the way the U.S. financial system operates. I’m not referring to the opinion piece by a departing Goldman Sachs Group Inc. employee, which suggested that the company has little respect for its customers.

If you have a complex derivatives transaction in place with Goldman -- or any other big Wall Street firm -- and you didn’t know they thought of you as a malleable “muppet,” it may be time to replace your chief financial officer.

Anyone who thinks this kind of hubris is new should read Frank Partnoy’s inside account, “F.I.A.S.C.O.,” published in 1999. Wall Street became a more aggressive and risk-loving place when trading increased as a line of business, but this happened way back in the 1980s by most accounts.

The truly dreadful news last week was conveyed in the results of the Federal Reserve’s latest bank stress tests. As presented by the Fed, most of the news was good. Some large financial institutions were judged likely to have sufficient equity capital even if the U.S. economy were to experience a significant downturn. With that, banks such as JPMorgan Chase & Co. were allowed to increase their dividends and buy back shares. Naturally, bank stocks rallied.

Economic Uncertainty

But there’s a problem, and it’s not a small one. If you buy the Fed’s view of what is likely to constitute stress, there is some justification for its action. Even then, you should ask the question that Anat Admati, a Stanford University finance professor, has been pressing: Why would we let banks reduce their capital in the face of so much financial and economic uncertainty around the world? If you leave shareholder equity on bank balance sheets, it still belongs to shareholders. Let it stay there as loss-absorbing capital in case the world turns nasty again.

Reducing bank capital, according to Admati and her colleagues, doesn’t help the economy. Bankers like lower capital levels because their pay is based on return-on-capital unadjusted for risk. Shareholders are willing to go along either because they don’t understand the risks of thinly capitalized and therefore highly leveraged businesses, or they expect to share in the downside protection that will be provided by the government.

Make no mistake: Lower equity at big banks means higher expected losses for taxpayers down the road. Don’t let anyone fool you into thinking that banking crises are costless. The disaster of 2008 caused about a 50 percent increase in U.S. debt relative to gross domestic product -- the second largest shock to the country’s balance sheet after World War II. (The details of this calculation and a broader perspective on today’s fiscal risks are in my new book with James Kwak, “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You,” which will be published April 3.)

And the Fed’s record as an economic forecaster is less than stellar. As chief economist at the International Monetary Fund in 2007 and 2008, I sat through innumerable meetings in which the senior Fed official painted a picture of the world that, in retrospect, was overly optimistic. When the Fed ran stress tests in early 2009, did it anticipate the depth and length of the U.S. recession? When it ran tests in late 2010, did it envisage even the rough contours of what became the European sovereign debt crisis? In both cases, the answer is no -- neither the Fed nor anyone else knows the future.

When the Fed leans toward the bright side, it isn’t accidental. As the organization that sets monetary policy and communicates the likely future direction of interest rates, the Fed feels the need to be careful about what it says, and goes out of its way to convey calmness.

Too Benign

For example, the Fed’s assumption in the stress scenario that Europe would have a mild recession seems too benign. My sources tell me that the Fed further assumed that only one large European bank would fail. But a single failure is a rarity -- either many banks do or they all receive bailouts, presumably depending on how public-sector balance sheets hold up and what happens politically.

But if the Fed implied, through its stress-test design, that it was seriously concerned about a major European meltdown, including perhaps a large restructuring of Italian or French government debt, what would that do to bond spreads and fiscal solvency around the world?

Another major omission from the stress tests is any serious consideration of interest-rate volatility, either with the economy far below full employment (as now) or if there is a faster than expected recovery. Long-term interest rates could easily rise if international investors shift away from holding dollars and the Fed decides not to resume buying long-term debt, which it had been doing to stimulate the economy. Short-term rates could also rise sharply. Either way, the Fed should examine the implications for banks.

Failure to do so is the kind of hubris we should fear. The Fed has an imperfect view of the future, as do we all. It has repeatedly demonstrated a limited ability to control economic outcomes. In light of this, the Fed could have required banks to build up shareholder capital on their balance sheets in case their aggressive risk-taking again becomes reckless and creates enormous losses.

Instead, the Fed is allowing big banks to reduce capital levels, increasing the likelihood of another financial and fiscal crisis and endangering the broader U.S. economy. We are all muppets now.

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