On Making The Stress Tests Permanent

ap081015072689The Financial Times reported today that Congress plans to make June the month in which the future of financial regulation will begin to take shape:

Congress will next month start the biggest regulatory overhaul of the US financial system in decades, bringing into the open a frantic lobbying effort between banks, regulators and policymakers on what it contains and who pays for it…Details of the regulatory overhaul – which also includes increased supervision of the retail market for financial products, standardising rules governing deposit taking institutions and increasing oversight of over-the-counter derivatives – are still being debated.

Of course, most of the effort is going to focus on systemic risk regulation and a new resolution authority for taking over and breaking down large, complex firms, as well as figuring out what to do with derivatives like credit default swaps. But another idea that has been percolating is making the stress tests — which were just performed on the nation’s 19 largest banks — a permanent feature of the regulatory regime. Time’s Stephen Gandel laid out some of the case today:

In good times and bad, bank regulators are supposed to be probing financial firms to see if they hold adequate capital for the loans they make…But unless you are a bank examiner or some other industry insider, those so-called call reports are nearly impossible to read and understand.

What was different about the recent stress tests was that unlike the usual bank-by-bank examinations, the stress tests looked at all the banks as a group…The stress tests also looked out two years, instead of the usual one, as regulators gauged if banks could weather a worsening of the economy — where the stress in the name comes from — and not just whether they had enough capital to pay for current losses. Most importantly, the results of the stress tests were publicized and presented in a way that was easy for most people to understand.

And as Sebastion Mallaby pointed out, “if a bank blows itself up, it can take others down with it, damaging the economy and handing taxpayers the bill. So government has a duty to force banks to plan for bad scenarios.”

Of course, designing the tests in a way that actually puts the banks through a bit of stress and doesn’t allow for intense lobbying regarding the results would need to happen. The first series of tests seems to have been aimed as much at quelling fear as at actually assessing the strength of the banks. But in theory, the idea of periodically assessing the ability of the financial system to weather an economic downturn seems like an eminently sensible one.