The Fed's Stress Tests Add Risk to the Financial System Banks have a powerful incentive to get the results the Fed wants and ignore other potential dangers. By TIL SCHUERMANN March 19, 2013 7:08 p.m. ET On March 14, after the markets closed, the 29 banks that hold about three-fourths of U.S. banking assets waited to hear if they passed or failed the Federal Reserve's annual stress tests. The results seemed reassuring. The Fed gave a passing grade to 14 and a failing grade to two, required two others to address some additional weakness by later this year, and didn't disclose its conclusions about the 11 smaller institutions.
Stress-testing got us out of the financial crisis in May 2009, and it has since become the crisismanagement tool of choice in the banking industry. But how well is it serving the country?
One unquestionably positive result is that banks have built up the capabilities to see how they would fare through different crisis scenarios. They must consider a mind-bending array of outcomes and have enough capital to deal with them—from what might happen to checking accounts and mortgages, to all those loans to develop shopping malls, to the derivatives that grease the global financial system. Bank regulators now can develop their own views of those questions and, more important, of the answers given by the banks.
This is a sea change. Regulators are always at an informational disadvantage—they don't underwrite loans or structure derivatives, they just try to check up on them. Before 2009, the only advantage a regulator had was the ability to see across all banks, comparing the answers and methodologies for reaching them. But there is no substitute for building your own models and coming to your own view. That is what the 2009 stress test did.
Since that first stress test, the financial ecosystem has seen an explosion of statistical and economic modeling. This is a positive development. I've done economic and financial modeling for two decades, including designing the Fed's quantitative assessment architecture for stress testing, which is the basis for the central bank's current process (the Comprehensive Capital Analysis and Review). Stress-testing has led to innovative thinking about risk assessment.
But there is another side to this. As the Fed's models have become more and more important in deciding the fate of the biggest banks, those banks have focused more and more on trying to mimic the Fed's results rather than tracing out their own risk profiles. This poses a real risk.
Remember that in late 2008 the largest U.S. bank holding companies were all adequately capitalized by regulatory standards. The market had a different view: Most were trading at less than book value.
It was only by trying something new, and by disclosing enough details so the market could "check the math," that bank regulators were able to regain the confidence of the public, and for the public to regain confidence in the banking system. Yet this "something new"—the formal stress-testing so important for the guardians of the financial system—is now inhibiting innovation among those that need guarding.
The incentives to get close to the Fed's numbers are powerful enough to stifle genuine creativity, imagination and innovation by risk managers and their modelers. Deviating from standard industry practice is now increasingly viewed with suspicion and often discouraged by bank regulators.
I understand this suspicion from my own days at the Fed: The modeling machinery built for the first stress test was in no small part designed to have an independent view on the output of "innovative" but dangerously flawed bank risk models, such as those for mortgage losses. But if everybody uses the same scenario (which they do) and works hard to get the same numbers (and they are trying), then we have a very narrowly specialized risk machine that is inflexible and unresponsive to unexpected shocks. That is, shocks that weren't previously subject to a stress-test.
The danger is that the financial system and its regulators are moving to a narrow risk-model gene pool that is highly vulnerable to the next financial virus. By discouraging innovation in risk models, we risk sowing the seeds of our next systemic crisis.
Mr. Schuermann, a former senior vice president at the Federal Reserve Bank of New York, is a partner at Oliver Wyman's financial services practice.