Editorial Board

If Only Banks Didn't Need Stress Tests

Steve Mnuchin lives in a parallel universe where banks have more than enough capital to ride out a crisis. The rest of us aren't so lucky.

How deep is the foundation?

Photographer: Daniel Acker/Bloomberg

If the Trump administration has its way, U.S. banks might no longer have to endure stress tests as tough as the ones drawing to a conclusion this week and next. And that would be great -- if only the banks were strong enough not to need them.

Stress tests started in 2009, when the U.S. used them to restore confidence during a financial crisis. Since then they've evolved into a more or less predictable regulatory exercise. Each year, the Federal Reserve conjures up a new worst-case scenario for the economy, and banks expend untold hours and resources to ensure they have just enough capital to squeak by. This time around, analysts expect U.S. banks to do very well, allowing them to return tens of billions of dollars to shareholders.

QuickTake Stress Tests

After several iterations, though, it's clear that the tests don’t really reflect the financial system's preparedness. For one, regulators have set the bar for passing far too low, at as little as $3 in equity for each $100 in assets for the largest institutions -- not enough to avoid distress. And the Fed's analysis tends to focus on individual banks, ignoring many of the interconnections that can amplify losses in a real emergency.

Stress tests certainly have their flaws -- but in a world where banks have so little capital, they're better than nothing. They help ensure that reported equity isn't the result of optimistic accounting, and they focus executives' attention on things that could go wrong. This is valuable, and could make the difference between the economy shrugging off the next major financial accident or being crushed by it.

So Treasury Secretary Steven Mnuchin is wrong in wanting to make stress tests less stressful. Some of his ideas, such as focusing the tests on the largest banks, make sense. But softening the worst-case scenarios, making the tests biennial, and de-emphasizing assessments of banks' crisis planning weaken the process too much.

If banks had enough loss-absorbing capital to be sure of surviving a crisis -- more than double the current level, according to the Minneapolis Fed -- stress tests could indeed be rolled back. Until then, at least for the biggest banks, they need to be toughened rather than dismantled.

    --Editors: Mark Whitehouse, Clive Crook

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

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