Three Federal Studies Show Fed’s Stress Tests of Big Banks Are Just a Placebo

The Fed's Stress Tests Are  Like the Wizard of Oz: An Illusion to Delude the Public

The Fed’s Stress Tests Are Like the Wizard of Oz: An Illusion to Delude the Public

By Pam Martens and Russ Martens: November 16, 2016

The only thing standing between the American people and another apocalyptic financial collapse among by the biggest banks on Wall Street is the Federal Reserve’s stress tests and capital requirements. After Wall Street laid waste to the U.S. housing market and economy from 2008 through 2010, while propping itself back up with a feeding tube from the taxpayers’ pocketbook, the Obama administration passed the Dodd-Frank financial reform legislation in 2010.  It wasn’t so much legislation as it was an illusory 2300 pages of rules that might someday get implemented in a meaningful way if President Obama appointed tough cops to his financial regulatory bodies – which he decidedly did not do.

One of the promises in Dodd-Frank was that the Federal Reserve would annually assess whether the biggest and most dangerous banks have adequate capital to withstand a severe recession and whether the bank has the proper risk-management programs in place to prevent it from imploding and becoming a ward of the taxpayer.

Yesterday, the nonpartisan congressional watchdog, the Government Accountability Office (GAO), became the third Federal entity in the last two years to indicate that the Fed is muffing the job of stress testing the big Wall Street banks.

The GAO report notes:

“…the Federal Reserve’s organizational structure for the stress tests does not include a formal process through which model development or risk management at the aggregate—or system-of-models—level is implemented…By largely focusing the modeling principles on the component models and not applying those principles to the system of models, the Federal Reserve has limited its ability to manage the extent to which model risk is introduced into the supervisory stress test models.”

Another failing according to the GAO report is this:

“The Federal Reserve also has not conducted analyses to determine if its single severe supervisory scenario is sufficiently robust and reliable to promote the resilience of the banking system against a range of potential crises. Such analyses—including performing sensitivity analysis involving multiple scenarios—could help the Federal Reserve understand the range of outcomes that might result from different scenarios and explore trade-offs associated with reliance on a single severe supervisory scenario.”

Last year, the Federal Reserve was criticized in a report by its Office of Inspector General over the models in its stress tests. But far more alarming was a report issued just this past March by the Office of Financial Research (OFR), which was also created under the Dodd-Frank legislation.

The OFR report brought the illusory nature of the stress tests into sharp focus. A careful reading of the report strongly suggests that the stress tests are being used to simply comfort Congress and the public with the notion that Wall Street banks are not going to rapidly morph again into an exploding fireworks factory, when, in fact, there is no basis for that confidence.

The OFR researchers who conducted the study, Jill Cetina, Mark Paddrik, and Sriram Rajan, found that the Fed’s stress tests are measuring counterparty risk for the trillions of dollars in derivatives held by the largest banks on a bank by bank basis. The real problem, according to the researchers, is the contagion that could spread rapidly if one big bank’s counterparty was also a key counterparty to other systemically important Wall Street banks. The researchers write:

“A BHC [bank holding company] may be able to manage the failure of its largest counterparty when other BHCs do not concurrently realize losses from the same counterparty’s failure. However, when a shared counterparty fails, banks may experience additional stress. The financial system is much more concentrated to (and firms’ risk management is less prepared for) the failure of the system’s largest counterparty. Thus, the impact of a material counterparty’s failure could affect the core banking system in a manner that CCAR [one of the Fed’s stress tests] may not fully capture.” [Italic emphasis added.]

It’s not that the Fed doesn’t have real-world experience that a failure by a major counterparty could rapidly spread contagion across Wall Street. That’s exactly what happened when the large insurer, AIG, failed in 2008. The U.S. government had to backstop AIG with $185 billion. Approximately half of the bailout money was then quietly funneled to the biggest banks on Wall Street to cover the counterparty guarantees on derivatives that AIG was on the hook to pay – but could not have paid except for the taxpayer bailout.

The March 2016 OFR study also reached the stunning conclusion that just six banks make up the “core” of the U.S. financial system. That’s six banks out of a little more than 6,000 commercial banks. That dangerous core includes: Bank of America Corp., Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase Co., Morgan Stanley, and Wells Fargo & Co. The researchers noted that while individual bank holding companies direct losses have declined under the Fed’s stress tests, “counterparty credit risks to the banking system collectively have risen and may suggest a greater systemic risk than is commonly understood.”

This counterparty concentration risk was also called out in the seminal report on the 2008 financial collapse by the Financial Crisis Inquiry Commission. The final report found:

“Large derivatives positions, and the resulting counterparty credit and operational risks, were concentrated in a very few firms. Among U.S. bank holding companies, the following institutions held enormous OTC derivatives positions as of June 30, 2008: $94.5 trillion in notional amount for JP Morgan, $37.7 trillion for Bank of America, $35.8 trillion for Citigroup, $4.1trillion for Wachovia, and $3.9 trillion for HSBC. Goldman Sachs and Morgan Stanley, which began to report their holdings only after they became bank holding companies in 2008, held $45.9 and $37 trillion, respectively, in notional amount of OTC derivatives in the first quarter of 2009. In 2008, the current and potential exposure to derivatives at the top five U.S. bank holding companies was on average three times greater than the capital they had on hand to meet regulatory requirements. The risk was even higher at the investment banks. Goldman Sachs, just after it changed its charter, had derivatives exposure more than 10 times capital. These concentrations of positions in the hands of the largest bank holding companies and investment banks posed risks for the financial system because of their interconnections with other financial institutions.”

Despite the devastation unleashed on the U.S. by the Wall Street banks in 2008, the worst economic collapse since the Great Depression, the biggest Wall Street banks now hold many trillions of dollars more in derivatives than they did in 2008. And, with the exception of Morgan Stanley, those derivatives are held at the FDIC-insured, taxpayer-backstopped, commercial banking units of the behemoth Wall Street banks.

A careful assessment of what the Fed has actually been doing with its much ballyhooed annual release of stress test results strongly suggests it is simply offering up a placebo for a malignant cancer eating away at the very heart of the U.S. economy and the future of the struggling young people of this nation.

It’s important to remember that this is the same Federal Reserve that secretly sluiced $16 trillion in cumulative, below-market-rate loans to the behemoth banks (while millions of families were losing their jobs and homes) and then fought a multi-year court battle attempting to keep the public from learning about this unprecedented action. Thanks to Senator Bernie Sanders and others, the public was finally afforded an accounting of this non-Congressional authorized bailout in a report by the GAO. (See Table 8 in the linked report to learn which banks got the lion’s share of the $16 trillion.)

The pent up anger of the American people, evidenced in the outcome of the November 8 election, has been brewing since the 2008 crash. Senator Bernie Sanders, in a 2012 Senate floor speech below, talks about the secret $16 trillion bailout by the Fed and puts his finger on the pulse of Americans’ continuing anger at a system that is only working for the one percent.


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