Congress Lifts a Stress Off the Financial System

by | May 31, 2018

Congress Lifts a Stress Off the Financial System

by | May 31, 2018

Congress has finally taken action to liberalize the nation’s financial system. The bill was S. 2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act. It passed both houses with a surprising degree of bipartisan support and was signed by President Trump last week on May 24.
Opponents cast the bill as a gift to the largest banks that will put the economy at greater risk for a new financial crisis.
In fact, the bill represents a modest and limited reform of Dodd-Frank. The law scales back an onerous regulatory exercise of questionable utility, and it actually reduces the artificial incentive for most financial institutions to get bigger.
The US financial system is still a long way from a true free market, but after this bill is implemented, the regulated market that remains will be less distorted than before.
What the Bill Does
The most important–and contentious–aspect of the new law is that it reduces the stress test requirements imposed on financial institutions.
Under the previous law, there were three tiers of stress test requirements based on the total assets of the financial institution:

  • $10B or less: No explicit stress test requirements.
  • $10B to $50B: Annual stress test required.
  • $50B and above: Semiannual stress tests required to be conducted. One of these tests will be subject to the Comprehensive Capital Analysis and Review (CCAR) process, which requires more detail and a compressed timeline relative to what is required for institutions in the $10 billion to $50 billion tier.

As the size of the financial institution increases, and the implicit risk to the stability of financial system grows, the regulations get more stringent and costly to implement.
The new reform bill, S. 2155, preserves the same general structure for stress testing, but it modifies the thresholds and some other details. The new total asset tiers and requirements under S. 2155 are as follows:

  • Under $100B: No explicit stress test requirements.
  • $100B to $250B: Stress tests required on a “periodic” basis; the definition of periodic is not immediately clear. The bill also includes a provision that allows the Federal Reserve Board (FRB) to impose, at its discretion, other prudential standards.
  • $250B and above: Annual stress test required, which would be subject to the CCAR process mentioned previously.

So as a result of the new rule, all institutions that are $10B in assets or above will have the regulatory burden from stress testing reduced to some extent. The largest institutions will only need to perform the test annually, instead of semiannually, while many smaller institutions will see the stress testing requirements from the Dodd-Frank Act eliminated.
Notably, these changes are set to take effect 18 months from the date of enactment for financial institutions with $100B or more in assets. Thus, the previous stress testing thresholds and requirements will continue to apply to them in 2018 and 2019.
The effective date of these changes for financial institutions under $100B in assets may occur sooner, depending on the way regulatory agencies choose to interpret the law. As of this writing, this interpretation is not yet certain.
Stressful Tests
Opponents of the new reforms argue that the thresholds for stress testing are far too high in S. 2155 and will put taxpayers at risk for more bailouts. Thus, one coalition lobbying against the bill accused the Democrats who crossed the aisle to support the legislation of being part of the #BailoutCaucus.
While it is heartening to see progressive groups making appeals to protect taxpayers, it is misguided in this case.
Such arguments take for granted that mandated stress tests really are an effective way to enhance and verify the stability of a financial institution. Somewhat paradoxically, the opponents also assume that the cost of completing such a test is relatively low.
As an example of this type of perspective, consider the comments offered by Dr. Dean Baker, an economist who has strongly opposed the recent reforms. Here’s how he explained the stress testing process in a recent interview:

The main part of the law that they changed was that they [the banks] had to undergo stress testing… What that means is that they just put their assets on a spreadsheet. So they say how many mortgage loans they have, how many car loans, business loans.

And then they’re…given a number by the Federal Reserve Board. Assume 10% of those go bad, and they’ll have an extreme case, assume 15%. I’m picking those numbers out of the air, but they’re given numbers and then they go, okay, how would our books look if that was the case?

That’s a very simple exercise, or at least it should be for any institution of that size. So the idea that this is some sort of huge regulatory burden is basically utter nonsense.

It’s hard to overstate just how incorrect this explanation is. Still, it’s useful to raise because I think it’s likely similar to the image many defenders of mandated stress tests have in their mind.
To people like Dr. Baker, this is just a minor exercise that helps stabilize the financial system, and the greedy snowflake bankers are making a frivolous complaint to their beholden lawmakers.
To people like me, who have directly participated in the Dodd-Frank stress testing process–and completed literally hundreds of pages of documentation related to it, per year—the stress tests are a serious and onerous undertaking that, in their present form, provide little discernible value.
Given this wide disparity between the perspective of pundits and practitioners, it’s useful to explain what the stress testing process actually looks like.
What Mandated Stress Testing Actually Looks Like
Pursuant to the Dodd-Frank Act, each year, the FRB publishes three new supervisory scenarios for use in stress testing: baseline, adverse, and severely adverse. As the names imply, the baseline scenario represents a business-as-usual environment with moderate economic growth; the adverse scenario reflects a minor economic recession; and the severely adverse scenario includes a deep economic recession, which is generally on par with the severity of the Great Recession, though it will vary in some particulars.
For each of these scenarios, the FRB provides 16 domestic variables and 12 international variables in total. These variables include economic metrics like GDP growth and the unemployment rate as well as some key interest rates. The variables are provided as a quarterly average for the next 13 quarters.
(Notably, contrary to Dr. Baker, the FRB does not provide loss rates for loans; companies are required to forecast these loss rates and be able to defend those forecasts as we’ll see.)
In addition to the variables, the FRB provides a brief qualitative description of what’s happening in each scenario, which runs around one page for each. Here are the scenarios that the FRB provided for 2018 testing cycle as an example.
And that’s it.
From this information, the company will need to forecast out their consolidated financial results–balance sheet, income statement, and capital ratios–for the next 9 quarters in each scenario. Since the end results will be reviewed and scrutinized by regulators, the company needs to be able to explain and support each aspect of those forecasts.
This is no small task.
One challenge that immediately arises in this process is that the range of variables provided by the FRB is insufficient for forecasting everything that is expected. For example, the FRB provides just six interest rates in its scenarios, and it omits many commonly referenced rates like 1-month LIBOR or the 1-year LIBOR, among others. Many loans use these types of rates as an index rate, so it’s necessary to know what they are in the scenarios to accurately project interest income and effective yields.
As a result, one of the first steps in the forecasting process is to find a way to forecast the values of the additional variables and interest rates that are needed. The company could forecast the variables in-house or pay a third party that has already forecast an expanded set of stress test variables. This is a good deal for the third party, but it represents a needless headache, and cost, for the company performing the stress test. In the real world, it would never be necessary for a company to derive these variables because they are all readily available in real-time.
With that hurdle addressed, the company can move on to the actual forecasting.
To give you a sense for the complexity of this process, let us consider what is involved in forecasting credit losses in these scenarios.
The first point to note here is that it’s not possible to forecast total credit losses for all loan balances in the aggregate. The total loan balance will include many different types of loans, each of which will behave differently under times of economic stress and will experience different loss rates. Likewise, different loan types will be more sensitive to some economic variables than others. For instance, a collapse in the home price index (HPI) variable would have a major negative impact on residential mortgages. As borrowers find themselves underwater on their homes, credit losses for this portfolio would rise significantly. However, one wouldn’t expect a drop in HPI to cause the same spike in losses for, say, commercial lines of credit.
So the company knows it needs to forecast credit losses, at least, at the portfolio or loan type level to have a meaningful outcome. In practice, the company could forecast at a more granular level, but we will stick with the loan type level to avoid over-complicating the example.
Preparing the baseline forecast is relatively easy. Most companies will already have some internal projections credit losses by loan type, and these projections will generally serve as a decent starting point.
Things get trickier when it comes to the adverse and the severely adverse scenario. The company can try to rely on their experience and the experience of peers in the past recession, but this will be highly imperfect. Here are a few of the questions that would need to be considered:

  • Have underwriting standards improved since the last recession? If so, then the average borrower may be more creditworthy and the portfolio should generate fewer losses.
  • Has the geographic concentration of the portfolio changed since the last recession? Although the FRB only provides national variables, some cities and some parts of the country tend to be more resilient than others in a downturn, which could impact credit losses.
  • How does the current scenario compare with the economic conditions in the last recession? Are the factors that impact this specific portfolio more or less severe than before?

All of these types of changes could have a major impact on the results. The company would need to take them into consideration to support their forecast, either qualitatively or quantitatively.
Then, once all the credit loss forecasts are developed, the company will use the results and determine various other line-items that are affected–provision for loan losses, allowance for loan losses, actual loan balances, and so on.
We’ve still only really scratched the surface here, but the example I’ve described is a simplified version of the process that could go into forecasting one part of the overall financial performance. Some items won’t be as complicated as credit losses, but the company will have to repeat a variant of this process to forecast all the other components of the financial statement in each scenario.
Suffice it to say, the full process requires a significant amount of work in order to produce a stress test forecast that can stand up to scrutiny. I’ll let you guess how many people have to be involved in the stress tests to complete them.
The First Crisis Without Uncertainty
Given all the work that goes into the stress testing process, you might hope that the result really is valuable. Unfortunately, this is far from clear.
In theory, the stress test is supposed to test how a financial institution will perform during another severe crisis. The problem is that the structure of the stress test removes one of the most critical and defining characteristics of an actual crisis: uncertainty.
As mentioned above, the FRB provides the scenario variables for the full 13-quarter duration upfront. In other words, the FRB is effectively telling companies what the path of the economy will be for the next 13 quarters. The companies know when the recession starts, how deep it goes, which aspects of the economy are hit hardest, and when the recovery begins to take hold.
In a real recession, of course, the financial institutions would not know any of these things. They might have an educated guess, or hope, but they do not know. They have to make critical financial decisions in a recession in the dark, and many mistakes will be made. This is how uncertainty works. But in the stress tests mandated by Dodd-Frank, uncertainty has been replaced by omniscience.
As a result, the severely adverse scenario is not really testing how a financial institution will fare in a deep recession. It’s testing something more specific, and less useful:
“If financial institutions have a crystal ball at the onset of a severe recession and have definite knowledge about the path of broader economy for next 13 quarters, will they be able to survive?”
Knowingly or not, that is the question that the Dodd-Frank stress tests are answering.
As a purely academic matter, I suppose the question is an interesting one. But we should not delude ourselves into believing that such a test is necessary or sufficient, to ensure financial stability.
Unintended Consequences
While the precise value of the Dodd-Frank stress tests is uncertain, the costs it imposes are quite real.
Under Dodd-Frank, the rigor and frequency of the tests escalated as the size of the financial institution increased. At $10B, financial institutions became subject to an annual stress test requirement. At $50B, financial institutions had to perform stress tests semiannually, and one of these tests would be subject to the more exhaustive CCAR process.
What’s important to note here is that once you’ve crossed a given threshold, the cost of compliance is largely fixed. That is, the absolute cost of performing a stress test for an $11B bank is not much different than the total cost of a stress test for a $49B bank. But since the smaller bank has much less revenue to offset this cost, the end result is that the stress test is relatively more harmful to small banks than larger ones.
This dynamic creates odd incentives. When financial institutions are about to cross the $10B or $50B threshold, they have an incentive to do whatever they can to keep their assets below the limit. They may try to sell off loans, pay down liabilities, divest subsidiaries, or take other actions to avoid breaching the limit and triggering large new compliance costs. Likewise, if a financial institution has just crossed one of these thresholds, it finds itself at an immediate disadvantage compared to its larger competitors. It has an incentive to pursue acquisitions or get acquired itself so it can dilute the fixed costs created by the Dodd-Frank stress tests.
In other words, one of the unintended consequences of Dodd-Frank is that it created artificial economies of scale. Although the law was intended to prevent banks from being “too big to fail,” one of its core features actually gave banks a huge financial incentive to get bigger. Is it any wonder that the leaders of America’s largest banks, like Goldman Sachs and Bank of America, have defended Dodd-Frank?
Since the new law doesn’t eliminate stress tests entirely, this artificial incentive will unfortunately still exist. But by moving the thresholds higher, the incentive will only apply to a smaller number of institutions. That is an improvement.
A Safe Prediction
When the next recession eventually comes, some banks will probably fail. Shareholders and creditors will lose money. If they have effective lobbyists, they might convince Congress that taxpayers should lose money too.
We don’t know whether the next recession will be better or worse than the last one. But we can be reasonably certain that when it occurs, this bill and its modest reform of stress testing, will be blamed by many pundits and politicians for causing the crisis. No doubt they will call for more regulation in response.
When that debate arrives, it will be important to separate fact from fiction with regard to the Dodd-Frank stress testing program. In the abstract, stress testing sounds like a good idea. However, details matter, and the types of stress tests mandated by Dodd-Frank do much more harm than good.
They are a significant drain on resources for small banks, they create an artificial competitive advantage for the largest banks, and because the stress tests remove uncertainty, they don’t even provide a meaningful simulation of how a bank will perform in a downturn.
Given all these flaws, reducing the scope of the stress testing mandate was a reasonable and admirable step towards liberalizing the US financial system.
Disclaimer
I am employed as a financial analyst at a bank. The views expressed above are solely my own and do not represent the views of my employer.
UPDATE (6/3/2018): This piece was updated to note that under the new law, institutions with between $100B and $250B in assets will still be subject to periodic stress tests.

About Eric Schuler

Eric Schuler is a contributor to The Libertarian Institute, with a focus on economics and US foreign policy. Follow his work here and on Twitter.

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