Fed misses a transparency trick with stress tests

November 18, 2010

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The newly powerful Federal Reserve may have missed a trick. The U.S. central bank, charged under the Dodd-Frank reform bill with broad oversight of the banking system, is asking the 19 biggest American financial institutions to submit to a series of stress tests. That’s a good thing. The trouble is the regulator plans to keep the results and the criteria used in the tests private.

That’s a shame. The stress tests that the Fed ran in early 2009 were critical to drawing a line under the financial crisis. By coordinating with other regulators, including the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Securities and Exchange Commission and the Treasury, the Fed minimized the ability of banks to game the system.

More importantly, it published worst-case and base-case scenarios for the economy and various asset classes. And at the end of the exercise, the Fed revealed the financial versions of electrocardiograms for all the institutions it deemed big enough to create havoc in the system if they failed.

That convinced investors that the Fed’s diagnosis of the firms’ health — or treatment needed — was appropriate and bolstered confidence in the system more broadly. Companies raised nearly $200 billion, some easily and cheaply and others with great difficulty, to shore up their capital and comply with the Fed’s requirements. The process helped end the panic that began in 2008.

Now, the Fed is putting banks back on the treadmill to evaluate their desire to begin increasing their dividends, buying back stock, or expanding. That’s unequivocally a good thing. But by keeping investors at large in the dark on the results, the Fed cannot hope to truly bolster confidence in the same way it did a year ago. Banks may feel that divulging so much information would be burdensome. But their too-big-to-fail status has conferred benefits, especially cheap funding. So some additional disclosure obligation seems fair.

The lack of transparency may not be entirely the Fed’s fault. It may be as much a flaw in the Dodd-Frank legislation, which mandates regular reviews of this kind but doesn’t detail their scope or require public disclosure. This may just be one of the first obvious defects in the law to come to light.

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