Entering the New Era of Banking Stress Tests

As technology and regulation continue to mold and catalyze a structural evolution in the banking sector, so must the commissions and administrations that oversee it.

Earlier this year, the Fed announced that it is considering an overhaul to its annual stress tests that are given to the United States’ largest banks, transitioning from a Pass/Fail grading system to a more comprehensive approach that would mandate a capital ratio as soon as 2019, as reported by Ryan Tracy at The Wall Street Journal last week.

Some believe this is a necessary step to ensure we do not encounter another economic crisis, but others remain skeptical of whether the tests truly gauge the integrity of our largest banks.

What are Stress Tests?

Following the devastation caused by the 2008 Financial Crisis that left many global economies in a state of despondency and led to the implementation of Dodd-Frank in 2010, the Federal Reserve and the International Monetary Fund (IMF) now conduct annual stress tests for all major banks. These tests examine whether each institution has enough capital to survive economic adversity and any tumultuous situations that may arise, as well as if they are able to continue lending in the case of a severe recession.

The tests, which are administered to banks with over $50 billion in assets, also evaluate banks’ internal risk controls, including credit and market risks. Essentially the tests are conducted to get an annual check-up of each bank’s financial health and ultimately take the necessary steps to improve their protocols if they are not up to par.

Stress Relief

Regulators began publishing the results of the stress tests in 2012. That year, four banks failed. However, since 2012, there has been only one year where more than two banks failed (five failed in 2014). In fact, in 2017 all 34 banks that were analyzed passed their respective stress test.

While the confidence in tier-one banks has certainly improved due to the positive results in recent years, regulators believe that a more thorough approach to these exams is warranted. The current test consists of two parts – a qualitative exam and a quantitative analysis. The qualitative aspect reviews subjective aspects of the institution, such as its internal organization and structure. The quantitative analysis objectively examines capital levels and financial figures. Banks must pass both portions of the stress test in order to receive a passing grade, but with the Fed’s proposed change, there would be more stringent requirements for the quantitative aspect of the tests.

What’s Next?

Federal Reserve officials have made no promises that a revamped stress test model would be implemented by next year, but it’s certainly possible.

As with any process in its nascent stages, the stress testing formula is due for a bit of an upgrade. To keep confidence in the banking landscape at a positive level and reassure customers that our banking institutions are able to withstand another possible crisis, this next phase should be welcomed by the public.

The banks, however, may have a different perspective.

Do you think the Fed is taking the right approach to stress tests? Weigh in here and let us know what you think.