Banks Are Better. But Not Stress-Free.

You're going to need a bigger umbrella.

Photographer: Thomas Lohnes/Getty Images

With financial markets showing increasing signs of instability and excess, investors might find it comforting that most of the largest U.S. banks have passed the Federal Reserve's latest round of stress tests.

They shouldn't be too comforted. Banks are operating with more capital than before the crash, which makes them safer -- but they still aren't safe enough.

QuickTake Stress Tests

The Fed's stress tests are designed to assess banks' ability to weather a bad recession and market rout. They've gone a long way toward making the financial system more resilient. The first round, in 2009, helped restore confidence at a critical juncture. Since then, annual tests have pushed banks to improve their risk-management systems and rely more heavily on capital to finance their activities. 

Yet the tests still aren't as tough as they should be. For one thing, they assess banks individually instead of looking at the system as whole. This pays too little attention to the contagion and credit freezes that compound losses in actual crises. 

In addition, calculating capital ratios is as much art as science. It involves placing values on hard-to-trade assets and, in most cases, weighting them according to risk. The Bank for International Settlements asked 32 banks to estimate a capital ratio for an identical portfolio of assets: Their answers varied by as much as four percentage points. The minimum capital buffer needs to be big enough to accommodate this further uncertainty.

Even if the tests considered true worst-case scenarios and if capital ratios were easy to measure, the Fed has set the bar for passing too low. The tests require that capital not fall below 4 percent of total assets. Research and experience suggest that this margin is too slender: Higher levels are needed to prevent distress in bad times.

The worst part is that most of the six largest banks only just cleared the Fed's low bar. Goldman Sachs Group Inc., JPMorgan Chase & Co. and Morgan Stanley made the grade only after adjusting their capital plans. In addition to ruling on whether capital is adequate, the Fed also considers whether banks' systems for capital planning are up to the job. Two flunked this further test: Santander Holdings USA Inc. and Deutsche Bank Trust Corp., the U.S. unit of one of the world's largest financial institutions.

Another bust will come, and it's crucial that the biggest banks are ready. This means requiring enough capital to ensure that they will not only survive but also be a source of stability. Erring on the high side would be better than the alternative. The costs of falling short, as we've learned, are just too grim.

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