Unintended Stress

Fed policy seems as twisted as this picture. Photo by Chip Somodevilla, Getty Images.

With much fanfare, the Fed released the results of the first part of its annual bank stress tests late Thursday. And the results seemingly show banks are under less stress than in the past. But another, separate report highlighted one risk the Fed seemingly isn’t properly considering—its own quantitative easing.

First, let’s dig into the stress tests’ details.

There are essentially two separate Fed tests banks face. The first, annual tests mandated under the Dodd-Frank Act, are designed to test banks’ capital adequacy under possible adverse scenarios (not forecasted conditions, but a concocted “negative” macroeconomic environment). These are the results the Fed published Thursday. In the second batch, known as the Comprehensive Capital Analysis and Review (CCAR), the Fed determines whether big banks (those often deemed “too big to fail”) should be permitted to proceed with potential plans to increase dividends or stock buyback programs. CCAR results are due March 14.

Last week’s Dodd-Frank tests showed 17 of 18 tested banks passed—an improvement from last year, when three failed. To pass, a bank had to show it would have a Tier 1 common ratio exceeding 5% in light of the adverse circumstances below:

• GDP growth of -5.0%
• A 12.1% unemployment rate (4.4 percentage points higher than the rate separately reported on Friday)
• Deflation at a -1.0% clip (as measured by headline CPI)
• A roughly 20% decline in home prices from present levels
• A 50% decline in stock prices

Based on these criteria, the Fed estimated industry-wide losses of $462 billion.

Critics are already contending the test was too easy, but in our view, these criteria for a hypothetical test are probably about as good as any. Realistically, arbitrarily selecting data for such a test is nearly always going to be subject to some criticism—either the bar’s too low or, as the one failing bank alluded to Friday, the tests are just outright flawed.

But in our view, the criteria aren’t really the issue. It is, rather, that the government—including the Fed—has no real, material track record of forecasting the timing, magnitude, cause or form of recessions.

While the above situation could easily be a stressful one on banks, the financial crisis wasn’t caused by any of the factors the test utilizes. Those are rough approximations of the effects of the financial crisis. Instead, the proximate cause was mostly well-intended-but-misguided regulation combined with the uncertainty brought by haphazard government responses. How would the government test for that? Is it likely they even would test for such unintended consequences?

Data published nearly simultaneously by the FDIC actually illustrated Fed policies are encouraging exactly the sort of banking behavior officials and politicians have been claiming is problematic. Traditional banking, which political rhetoric (like pushing for the Volcker Rule) has us believing is the type of banking Fed officials and regulators want to spur, is the business of generating profits by borrowing cheaply in the short-term and lending the funds at higher, long-term rates—generating a spread, or net interest margin. However, the Fed’s QE-infinity has lowered long-term interest rates. Short-term rates can’t fall much from their currently non-existent levels. The result is less profitable traditional banking, illustrated clearly by FDIC data showing net-interest margins fell at 67% of US banking institutions year-over-year. (This shouldn’t have surprised anyone at the Fed—this is Banking 101: flatten the yield curve, and you sap bank eagerness to lend.)

Ostensibly, the Fed’s pursuing this policy targeting increased loan demand—figuring that’s behind relatively slow loan growth. Yet the focus on spurring loan demand through low rates pinches loan supply—the classic economic folly of focusing on one group (borrowers) to the exclusion of the other interested party (lenders).

Yet while traditional banking profits were under pressure, overall profits at US banks grew by nearly a third in the same period—driven by trading revenues, loan sales and other entries. Now, we don’t view trading activity or these other actions as necessarily problematic or risky. Most of the profit-generating trading is part of normal, modern-world bank operations—often done to hedge risks or simply serve the needs of bank clients. But we’d suggest the Fed’s rhetoric doesn’t match the unintended (but unsurprising) result of its actions. With foreclosures, delinquencies and charge-offs of non-performing loans all down sharply over the past year, our guess is banks aren’t finding failing loans to be much of a stressor these days relative to recent years. Too bad we can’t say the same about Jekyll and Hyde policy from the Fed.