Why Do Banking Regulators Bother to Conduct Faux Stress Tests?

One of the many proofs that banking regulators do not believe that financial markets are even remotely efficient is their continued use of faux stress tests to reassure markets. But why do markets need reassurance? If markets do need reassurance that banks can survive stressful conditions, why are they reassured by government-designed stress tests designed to be non-stressful?

Stress tests were first mandated for Fannie and Freddie by statute. Fannie and Freddie’s managers referred to them as “nuclear winter” scenarios – impossibly unlikely and stark disasters. The managers used the ability of Fannie and Freddie to pass the stress tests as proof that the institutions were safe and so well capitalized that they could survive even a lengthy depression. In reality, Fannie and Freddie had exceptionally low capital levels. Fannie and Freddie met their capital requirements under a newly toughened version of the statutory stress test weeks before they collapsed and were revealed to be massively insolvent.

AIG passed its stress test immediately before it failed. The three big Icelandic banks passed their stress tests shortly before they were revealed to be massively insolvent. Lehman passed its stress tests. The stress tests ignored the actual primary causes of losses and failures – extreme losses on fraudulent liar’s loans and CDOs.

For my sins, I read every one of FRBNY President Geithner’s speeches discussing regulation. Geithner is a one-trick pony. His answer, to everything, was stress tests. He claimed that the largest banks had developed advanced, proprietary stress tests that provided ever increasing assurance that they were safe and well-capitalized. The crisis revealed that the models and the safety were illusory.

Geithner and Bernanke ignored the lesson of the crisis and created stress tests that were as fictional as the industry’s failed stress tests. The U.S. stress tests, designed by Fed economists (and that is frightening given their role in causing the crisis) were largely conducted by the largest banks. To everyone’s surprise, they found that the banks were overwhelmingly sound and well-capitalized. The stress tests, however, largely excluded the banks’ losses on liar’s loans and CDOs.

The EU’s stress tests have excluded the banks’ exposure to sovereign debt risk despite the rise of sovereign risk so severe that it could render a number of banks insolvent. German Prime Minister Merkel’s coalition has just lost its sixth regional election (out of the seven most recent elections). Germany’s economic “success” is mixed. It has reduced unemployment, but its middle and working classes have seen flat or even declining incomes. This economic record is one of the reasons why Merkel’s coalition has been losing elections. Merkel’s most acute political problem, however, is that the purported bailout of the periphery is profoundly unpopular in Germany.

The obvious question is why Merkel (eventually) supports the bailouts. The answer is that German banks are the largest single beneficiaries of the bailouts – and much of Europe subsidizes the bailout of German banks by the EU. The German government claims that German banks are sound, but their actions constant betray these claims. The Germans have insisted that any increase in capital requirements in Basel III be phased-in slowly over roughly a decade. The sole reason for the German position is the fear that several large German banks are so insolvent that they would not be able to meet the Basel III requirements. The German banks’ imprudent loans caused great harm in the periphery. (“German Banks Gone Wild!”) Their inadequate capital poses a severe danger to Europe and the U.S. The German regulators have insisted that their banks’ exposure to sovereign risk be excluded from the stress tests. (The European stress tests mirror the U.S. stress tests in largely excluding losses from fraudulent loans.) The Germans have, after allowing the periphery to twist slowly in the wind for months, ultimately favored bailouts of the periphery because they fear that allowing a sovereign default would make obvious the German banks’ large losses and reignite the financial crisis.

Which brings me back to my original question – why are so many banking regulators insisting on conducting faux stress test when everyone knows they are rigged? One need not believe in the efficient markets hypothesis to believe that anyone sentient in the markets must know that the stress tests are shams. The public doesn’t believe, and doesn’t need to believe, that the largest banks (the systemically dangerous institutions (SDIs)) are financially sound. The public believes that the government will bail out the SDIs and protect their depositors from losses. So please join me in urging an end to the farcically faux stress tests.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

(Cross-posted from Benzinga.com)

This post appeared at New Economic Perspectives and is reproduced with permission.