Bill Black: Why do Banking Regulators bother to Conduct Faux Stress Tests?

Yves here. This is a subject near and dear to my heart. There is one bit that Black is missing, however. McKinsey advised the Treasury on the stress tests. They discussed it openly at a presentation at an alumni meeting.

By Bill Black, an Associate Professor of Economics and Law at the University of Missouri-Kansas City. He is a white-collar criminologist, a former senior financial regulator, and the author of The Best Way to Rob a Bank is to Own One. Cross posted from New Economic Perspectives

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.

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  1. Thomas E

    The reason for these stress tests is obvious – culpability. If you are the investor in a big fund, you can sue that fund if they invest in a clearly bankrupt bank. If the government produces a stress test that says the bank is solvent, as a fund manager you can invest in the bank without risking a law suit.

    People know the banks are insolvent, but as long as the government is going to bail them out, they know they will make a lot of money investing in insolvent banks.

      1. KnotRP

        Culpability is probably one goal.

        Another goal is probably to pay consultants
        to be part of the “Banks are sound” team,
        getting them to watch the flank and lie where
        helpful to the cause.

        1. nonclassical

          …has anyone else heard that actual bank AUDITS were legislated away towards the end of Clinton adm., by paper slipped into other legislation by Phil Gramm?..making it now illegal to AUDIT banks..?

          1. SidFinster

            Not true.

            For confirmation, look up any US bank with shares traded on a US securities exchange, as they are required to provide audited financial statements. Every FDIC-insured bank is also audited, but I do not know whether the audit report must be disclosed to the public.

            Even the few non-FDIC insured banks are also probably audited under state law banking safety and soundness rules.

      2. Jim

        Reason for the Tests?

        To draw in the marginal retail investor to support the stock.

        Equity markets are priced by that marginal investor, whether it be at the institutional or retail level.

        And if institutions are cashing out, you need to give the retail investor a reason to believe, to explain to his/her spouse why he just made an investment in Bank of America.

        And the Federal Reserve saying that BAC just passed a rigorous stress test is as good as any.

    1. steelhead23

      I think you are spot on. Excellent thinking. Geithner knows the SDIs need capital. But if they admit to insolvency, a large fraction of potential investors would be forced by their business model and commitments to not invest. Knowing that the gov’t has called “all clear” allows the big funds to buy and hold bank stocks, reducing the potential that cash flow problems would cause the banks to shutter their doors. Excellent thinking. Black likely knows this as well – I wonder why he doesn’t mention it.

    2. zebulon

      so many people miss that the legal structures created to support these fictional finances are at the root of the problem.

      and legal structures, are themselves the very heart of governance, because they can only be torn down through a complete political overhaul, which ordinarily comes by revolution or by some sort of collapse, but perhaps a president using emergency powers could do the trick.

      one cannot change the legal structure ‘gradually’ through the ‘legislative proces”. that is akin to simply supporting the method of lobbying which is used to control this method to begin with. ‘changing’ the legal structure must happen not by legislative control but by non–legislative control, i.e. by the decree of a powerful group or person (president, the military, ‘the people’ , ‘the states’…….anyone but the federal legislatures and beauracracies )

  2. barry

    The Treasury paid taxpayer funds to get advice from McKinsey & Company???????

    The company that charges millions to tell banks that 80% of their revenues come form 20% of their customers?

    And cross selling business services to retail customers and cross selling retail services to business customers can be profitable?

    Simplest stress test: who will trade with the bank if they lost access to the discount window and FDIC insured deposits?

    1. F. Beard

      Simplest stress test: who will trade with the bank if they lost access to the discount window and FDIC insured deposits? barry

      Good thinking. To carry it further, who would deal with the banks at all if ALL government privileges for them were eliminated and if insolvency laws were vigorously enforced?

      The government certainly does not need banks since it can create, spend and tax as necessary (to control price inflation) its own fiat. As for the private sector, is it incapable of creating its own financing solutions apart from a government enforced private money monopoly?

  3. Jack Straw

    The Russina soul has Dostoyevsky and Tolstoy etched into it. The American soul has the Music Man. On second thought, everybody has the Music Man in their soul now. That’s why these finance guys get the big bucks.

    “She tries to give Mayor Shinn evidence against Harold that she found in the Indiana State Educational Journal, but they are interrupted by the arrival of the Wells Fargo wagon, which delivers the band instruments (“The Wells Fargo Wagon”). When Winthrop forgets to be shy and self-conscious because he is so happy about his new cornet, Marian begins to see Harold in a new light. She tears the incriminating page out of the Journal before giving the book to Mayor Shinn.”

    It’s never been a better time to buy a house!

  4. Expat

    It’s propaganda, pure and simple. Why do we think propaganda is something done only by Goebbels or the Soviets? Americans are fed lies and distorted truths from their first days in kindergarten. Tales of Paul Revere’s ride, the Pilgrims, and the treatment of Native Americans.

    How about the noble and decent American soldiers of WWII? German troops were terrified of being slaughtered by the Airborne. The myth that Japanese fought to the death or committed suicide for cultural reasons is also partly a lie; US Marines simply did not take Japanese prisoners as a rule. In fact, the situation was so bad that the US high command offered soldiers extra leave if they would bring in prisoners.

    So, the bank stress tests are just more bullshit from the boys in Washington and on Wall Street. Classify it along with “Just Say No”, Abstinence Only Teaching, Color-Coded Terrorists Alerts, Horatio Alger, Truth, Justice, and the American Way.

    I would love to see one, just one, mainstream media outlet call bullshit on these things. Could you imagine a WSJ front page saying “Wall Street Stress Tests are Lies and Propaganda”? No, neither could I.

    It’s time to remove every single politician and CEO in this country from power. Send them to Gitmo, Helmsland, or Iowa…anywhere unpleasant. Let’s start again.

    1. citalopram

      The American propaganda machine is so slick and pervasive it makes the Soviet and Nazi methods crude in comparison. I personally think a lot of what’s on TV (cop shows) and movies MIGHT be all linked to some Pentagon black budget somewhere, and it’s been going on for years. The MSM is most definitely been corrupted by the feds, and that’s been known for decades.

      It’s not what they tell you, it’s what they leave out.

    2. robert57

      Recommended reading — Iwo Jima by Richard Newcomb.

      Suicide was a major theme of WWII. Not just among the Japanese, with their most well-known example, the kamikazes. Germans were expected to happily sacrifice their lives for the glory of the state. Hitler thought that having strongholds fight to the death was a good way to exhaust the enemy. In the end Hitler killed himself, and scores of citizens on the eastern front did too rather than face Russian troops. Scores of American Marines fell on grenades to save their fellow soldiers, another version of suicide for the nation.

  5. Slim

    Because they really genuinely think that this economy is a perception problem. They think if people just think that we are okay, they will return to spending 110% of their income. Remember when Phil Gramm slipped and told what (he thought) was the truth – that the recession was “mental” and America was “a nation of whiners”? Well, since the same folks are STILL running the show, and nothing has changed, and they are still dedicated to getting things back to early 2007, why not do some fake stress tests?

  6. Jim A

    I think the problem is that “everybody” doesn’t know. I suspect that it’s not Wall Street that they’re trying to convince, but Main street. Not so much stockholders but depositors.

  7. hello

    The stress tests are a perfect example of Hanlon’s Razor.

    Never attribute to malice (I’d also add conspiracy) that which is adequately explained by stupidity.

  8. jaymaster

    Could the answer to Bill Black’s question be that the stress tests are an easy way to dole out money to favored and/or politically connected firms?

    Yves, you might be able to answer this better than anyone. What kind of fees can these firms earn by running a stress test?

    I would assume the test is typically performed by an outside consultant, for the appearance of some impartiality. Seems like easy money. Kind of like the ratings agencies. Heads I win/tails I win.

    1. Just a thought...

      You would assume but you’d be wrong. The tests were designed and are administered by regulators. Feed back from banks is incorporated into the process, in an effort to capture unique asset/deposit characteristics within individual firms, but the tests are regulator driven.

      No comment on the sufficiency of the effort , but I would generally say that if risk management efforts don’t ask the right questions, they don’t get the right answer.

  9. chris


    As two plus two still equals four (except in oligarchical collectives)-

    “The sole reason for JPMorgan Chase’s position is the fear that they and their Wall Street brethren are so insolvent that they would not be able to meet the Basel III requirements.”

  10. prophetwithoutprofit

    I think there is another explanation. Where the stated goal of Bernanke and by implication, the Administration is to drive up equity prices, passing the stress test provides a headline for the HFTs and other flash and momentum traders to drive up stock prices. The same headline game is being played with Greek default or bailout possibilities. Rational, sophisticated investors know that Greece will default, yet the market hangs on every headline rallying or crashing on the headline du jour.

    In this type of cynical,trading world why not create the headline of a positive stress test to drive up bank equities? You kill two birds with one stone: bank stocks go up raising the entire market and creating a wealth effect and longer term it permits the banks to re-capitalize by issuing equity and taking the Fed and the Treasury off the hook. From a short to intermediate term perspective this is win-win. From a longer term perspective we see the bank stocks rose in 2009 and 2010, plateaued earlier this year and are now in decline as the inexorability of their bad financial position becomes obvious to the markets.

  11. Susan the other

    For a long time I have believed that we were the pushers of debt, worldwide. I kept thinking that it was because we had so much money, dollars, out there in circulation to the rest of the world, which we gave to any “ally” during the cold war, that we had to keep using it, keep loaning it, keep capitalist growth at a maximum in order not to implode. So my assumption has been that the huge insolvency mess we are in now denying is just our way of mopping it all up. It was probably the default plan. No pun intended. If maximum growth capitalism hits the wall, we’ll just fake our way through this, rake up as many escaped dollars as we can, and burn them. And the assumption had to have been that it would cause massive and long term unemployment. For which there is no plan.

    1. monday1929

      I think I’ll wear my old bright green trading jacket and badge down there next time. Cops won’t know whether to beat me or escort me out of harms way. I have a feeling they’ll just beat me. Cops should be put on notice that they will be held fully accountable for any brutality.

  12. Hugh

    Banksters are con men and stress tests are part of the con. They give cover to business as usual, the business in question being looting.

    Re Hitler and Stalin, there are interesting parallels between totalitarianism and kleptocracy. As Hannah Arendt noted in On Totalitarianism, totalitarian movements keep up a fiction of normalcy which they project to the non-totalitarian world, both within and outside their country. These fictive gestures are meant to reassure and preempt action against them. In general, however, their real intentions are the opposite of their stated ones. Similarly, stress tests are meant to reassure the non-kleptocratic world and prevent action against the banksters, even as they allow the looting by our kleptocratic elites to go forward.

  13. monday1929

    I always thought “Stress” Tests were conducted to give me better entry prices on Puts. What other possible reason could they exist for?
    They do provide cover for fiduciaries. Those who run 401K’s need the cover to keep Ma and Pa in the markets till the bitter end. Stress Tests serve same purpose as S&P and Moodys did- lets fiduciaries escape prison sentences.

  14. chris

    the one thing, well wait the many things we have gotten out of this recession/stress test/slash stimulus etc… that we no longer have a capitalist economy, have not had it for a long time, and that the government is complicit in the shams and scams of Wall street and that where the money is there is no law, there is no rule and there is no justice, the stock market is a printing machine for the oligarchs and the less people investing in the stock market the better for those who own majority of shares —thinly traded stocks are easiest to manipulate by big money to line their pockets, go long go short, go long go short….perfect plan. Throw in a few HFT and you have a printing press for the wealthy.
    And the rest of them are in banking who take the tax payer money and launder it so it can go into their bonuses.

    It is a great plan and looks like no one will ever stop it. People have been brainwashed so long that they think the stock market is perfect pricing and an uncontrolled beast. But manipulation is the way of the big money and the regulators and government are bought and paid for and refuse to demand any fairness in trading, especially after they over saw the meltdown that put all the money in the hands of the elites. those with power to do anything have no interest in playing fair.
    Why would they?
    The banks have fabricated numbers for years, the stress tests are laughable because the banks are fabricating numbers as always. The banks also have been given the freedom to re write property laws to wipe out hundreds of years of precedent with the approval of many judges and all of the government.
    We are seeing it all unfold before our eyes. The fix is in and it is worse than anyone would have imagined.

    It doesn’t look like there is a force strong enough to remedy the situation so the average citizen has a chance to use a solid work ethic and hard work to their advantage. Everyone is left looking for an edge or an advantage to try and compete.

  15. tiebie66

    “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 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 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.”

    The above extract appears to me to be the author’s message. If so, why? Are these statements true in absolute or relative (i.e. to bank solvency in other EU countries) terms? Why is the U.S. so vulnerable to the condition of German banks? If Greece defaults, more harm will come to Germany (via its banks) than to Greece via a default? Germany is less able to withstand insolvency of its banks than Greece?

    Something does not add up here and if someone could enlighten me as to where I misinterpret the post, it would be greatly appreciated, thanks.

  16. Fiver

    Since we know for a fact that Geithner, Bernanke et al will happily throw whatever’s left of the law or prudence under the bus without batting an eye (and are very likely already doing so re Europe) I agree with those who say it’s not just to provide cover/buy time/loot money for banks, but that such manufactured BS is now a regular tool for actively managing performance in “markets” for optimal sustained predation. “Saving” the world is very, very profitable.

    It must be a special kind of Hell for Black to see how far into the sewer it’s all gone.

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