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March 6, 2015

Federal Reserve: Every Bank Passed The Stress Test; Should The Fed Make The Exams Harder?

“On Thursday afternoon, 31 of the largest U.S.-based banks got a clean bill of health from the Federal Reserve. In the first round of its annual stress tests, the Fed found that every bank holding more than $50 billion on its books would stay solvent enough in a deep economic downturn to continue operating.

“The full results of the stress tests, including a subjective judgment of banks’ internal risk controls, won’t be publicized until March 11. But the 100 percent passing rate on the first phase, unprecedented since the tests began in 2009, raises questions about whether the stress tests could really foretell, let alone forestall, the next financial crisis.

“Those concerns were underscored this week in a paper from Columbia University and a Treasury Department unit that suggested the Fed’s results have grown too predictable. “The pattern suggests a missed opportunity to diversify the types of stresses tested,” the authors warned.”

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“There’s no question that the stress tests, together with the regulatory framework that shapes them, have pushed banks to moderate their risk-taking. The largest firms have added roughly $500 billion to their cash reserves since 2009. The industry’s capital ratios – the proportion of safe assets to volatile liabilities on the books – have risen well above precarious pre-crisis levels.

“But behind those visible changes lies a process that remains in the shadows. “The biggest flaw in the system is the secrecy that surrounds the stress tests,” said Dennis Kelleher, president of the group Better Markets, which advocates for financial reform. “The Fed does release some information about the stress tests, but nowhere near enough for anyone to independently evaluate the model.”

“Though the Fed publicizes its scenarios and final judgments, its rationale remains highly guarded. Banks, too, are discouraged from openly discussing the process. This secrecy stems in part from banks’ desire to keep proprietary information private, in part from the Fed’s desire to keep banks from reverse-engineering the process.

“But the confidentiality of the Fed’s testing process leaves the public uninformed, Kelleher said. “The fact there are stress tests at all is a dramatically important improvement in regulation,” Kelleher said. “But the Fed itself would benefit from transparency.” He suggested that the Fed disclose the inner workings of each stress test a year after the fact, to be pored over by researchers and watchdogs.”

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Read the full International Business Times article by Owen Davis here.

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