Stress Tests On Big Banks Are Too Predictable, Treasury Department Paper Says

The stress tests meant to ensure that big banks are safe and sound have become too predictable, experts warn in a paper published by the U.S. Treasury Department Tuesday. The researchers show that the examination process is settling into a routine, as evidenced by results that come back largely the same year after year.

“The results of the Federal Reserve’s bank stress tests suggest a trend toward greater predictability,” the authors wrote. In the past two years, the researchers found potential bank losses to be “nearly perfectly correlated,” a surprising finding for such devilishly complex simulations.

The Federal Reserve carries out stress tests to ensure that the risks held on banks’ books won’t drag them down in a downturn. A centerpiece of postcrisis financial reform, the exams have become an annual obstacle course for financial institutions to negotiate. Investors scrutinize the Fed’s scores, and executives are held to account for any stumbles.

But when researchers at Columbia University and the Treasury Department’s Office of Financial Research crunched the numbers from the test results, they found a “striking” amount of regularity over time. Either banks have found a shortcut or the game has grown too easy.

The findings echo concerns that stress tests have become just another regulatory hurdle. In a 2013 op-ed in the Wall Street Journal, Til Schuermann, a former senior vice president at the Federal Reserve Bank of New York, worried that “banks have focused more and more on trying to mimic the Fed’s results rather than tracing out their own risk profiles.”

Meanwhile, banks have earned scrutiny for papering over the potential hazards on their books. In 2012, JPMorgan Chase & Co.’s so-called London Whale came to light, with a surprise $6.2 billion loss on credit derivatives that startled its shareholders and competitors alike. A 2014 report faulted the Fed for failing to investigate the suspect trades, which it spotted several years before they blew up.

But the findings come as no surprise for some. “It’s not a terribly damning indictment of the stress test,” said Rebel A. Cole, a professor of finance at DePaul Univesrity. “These banks are like aircraft carriers. They turn very slowly. Wouldn’t you expect things to stay similar year to year?”

In its annual stress tests, the Fed presents banks with three economic forecasts ranging from “baseline” to “severely adverse,” each of which includes 28 variables. Despite all these moving parts, the tests use “essentially the same scenarios every year,” according to Cole.

The results may also look similar year after year because banks hold roughly the same assets over time. Although firms such as JPMorgan and Citigroup Inc. have altered their portfolios to align with new risk requirements -- ditching commodities desks or reining in speculative bets, for instance -- their core investments remain stable.

Privately, though, banks complain the tests have become an enormous burden. Firms have reportedly hired scores of new staff to meet compliance standards. At the same time, they’ve spent billions of dollars to increase their capital ratios -- the amount of effective cash banks must hold in relation to debts and liabilities -- calculations that play central roles in the stress tests.

The country’s largest financial firms have even reportedly created a loose study group, trading notes and pointers in advance of making their submissions. The Fed discourages banks from speaking openly about stress tests.

The stakes are high. For instance, Citigroup has failed part of its stress test twice. The bank rehired its former banking head Gene McQuade last year for the express purpose of acing the exam this year. CEO Michael Corbat is reported to have his job on the line pending this year’s results, with the first of two Fed batches expected Thursday.

When the results do come, however, they’re unlikely to look terribly different from last year’s, according to the recent research. And, although Cole found the paper’s conclusions self-evident, he agreed they highlight a larger concern. “Regulators have a history of not actually stressing the risks that would cause the banks to fail,” he said.

The study’s authors sounded a similar note. “Whereas the results of stress tests may be predictable,” they wrote, “the results of actual shocks to the financial system are not, and herein lies the concern.”