Stress tests: The results are in, now what?

May 8, 2009

Mark_Williams_Debate— Mark T. Williams, who teaches finance at Boston University’s School of Management, is a former Federal Reserve bank examiner. The views expressed are his own. —

The market has anxiously waited over two months.  With the stress test results in, we now have our work cut out for us.  Not that these findings were surprising, as the 10 banks which made the government’s “need to raise additional capital now” list are the usual suspects, such as Bank of America (BofA), Citigroup, Wells Fargo, SunTrust, Fifth Third, KeyCorp, and Capital One.  They were problem banks before the tests and they continue to be.  But this painfully drawn-out process has spawned four tangible benefits worth discussing.

First, the stress test results raise an important policy question:  Should our largest banks, those central to our economy, be allowed to take such large risks? These results paint a clearer picture of the level of risky lending practices that many of our 19 largest banks engaged in over the last decade. The government’s assessment provides added support to the need for re-regulation in this vital industry.  In the worst-case scenario, the Fed reported that these banks, which control the majority of our country’s deposits and loans, could need to raise approximately $600 billion in additional capital just to cover increased loan defaults.

Second, the stress test results show that risky bets were not just concentrated but spread over many areas, including trading and financial contracts, first and second mortgages, commercial loans, securities, and credit cards.  Having more detail on the sheer scope and size of these risky bets and potential losses provides a stronger case for the need to revamp the capital standards currently applied to banks.

It also raises the question of how the Fed and other regulators might monitor the on-going level of bank risk-taking activities.  Under the existing Tier 1 regulatory capital standard, almost all 19 banks pass with flying colors, yet the stress tests show a bleaker picture as the majority failed this equally important financial health test. The level of risk they are taking, should the economy weaken further, can not be supported by their current level of capital. Tests indicate that the 10 weaker banks need to raise approximately $75 billion to cushion against those losses.

Going forward, higher regulatory capital standards should be mandated. Banks also should be discouraged from risky lending practices, and a new Glass-Steagall type act, which was unfortunately repealed in 1999, needs to be put back on the table.  Doing so will help to separate higher risk-taking banks from lower risk-taking banks.

Third, the stress test results highlight the fragility of our banking industry and the need for bankers to rethink what are acceptable levels of risk taking.  Not long ago, the term “stodgy” was used to describe a bank or banker.  Today it’s more accurate to use “risky.”

Fundamentally, banks attempt to make money only three ways — interest loans, fee-based products and services, and proprietary trading.  Each has a varying degree of risk.  What makes one bank willing to take more risk than another is driven by management risk appetite, the perception of risk being taken, and the amount of capital to support such risk taking.  A bank with lower capital is a boat that needs to stay close to shore.  Banks with higher capital have greater ability to go out to sea, take risks, and weather a financial storm.

As expected, some bankers see an inherent conflict with large capital reserves as this can reduce their perceived returns.  While bankers have no control over the economy, they have absolute control over the level of risk that they take and the capital levels they deem as adequate.  Ideally, bankers should take these factors into account as they continue to recalibrate their risk-taking activities to match the level of capital needed.

Fourth, the government’s very public stress-testing blitzkrieg elevated general awareness of the benefits of using such risk-management tools in evaluating and planning around possible adverse financial outcomes.  And while stress testing has been used for decades by banks and regulators, the fact that banks overdosed on risk over time and not overnight suggests that such tools were infrequently used or ignored in the pursuit of seeking excessive profits. Also, more aggressive model assumptions can and should be applied. Going forward, with elevated awareness of stress testing, bankers and regulators should increase the effective use of risk-management and planning tools in managing bank-related risk.

Some banks have a greater propensity to overdose on risk, regardless of the initial size of their boats.  Many, such as BofA, Citigroup, Wells Fargo, and Capital One, are out to sea in a financial typhoon and now must be brought (or towed) back to safe harbor.  Stronger capital requirements, better regulatory risk oversight, and bankers with a stronger handle on fundamental risk-management principles should help reduce the chance of another banking meltdown.


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Banks were prohibited from holding stocks and other securities until Ronald Reagan. In the early to middle 1980s a banking collapse was imminent. The FDIC had about 25 billion dollars to shore a 50 billion dollar liability. Depression era regulations were repealed so banks could invest in securities. Banks posted enough profits on these investments to pull themselves out of the mess they were in with little capital assistance from FDIC.

Subsequently savings and loans collapsed. As they were prohibited from securities investments, they could not offer the same kind of interest rates the banks now could, so savings and loans went the way of the dinosaur. By the way, that savings and loan collapse cost the government 300 billion dollars. We would have been better off to raise taxes, shore up FDIC and let a few banks go under.

Today as in the 1980s banks get preferential treatment and are not held accountable for poor management. We are allowing our manufacturing base to erode but our precious banks must be saved. I wonder how many Americans know that the Federal Reserve Board represents the largest and wealthiest bankers in the U.S.? And that we as a nation pay them interest to use their money to run our economy. We gave them and their governing board authority to print dollars. Around the time the Fed was signed into law, Federal Reserve Board member banker Barron Rothschild stated “I don’t care what kind of government we have as long as I control the money”.

The U.S. Constitution is clear. The power to mint and regulate currency is the charge of Congress. Any change in the distribution of governmental power should be addressed by Constitutional Amendment and not a legislative act of Congress. Of course the same could be said of the War Powers Act, Homeland Security Act and Patriot Act. Am I the only one who sees a disturbing trend here?

Posted by Anubis | Report as abusive

Hello Mark,

As we know the capital adequacy framework depends in large part on the risk measurement framework. The risk measurement framework needs to be revised and thought through very carefully. Traditional statistical approaches such as historical Value-at-Risk (VAR) have performed poorly and bring to mind Disraeli’s remark

“There are three kinds of lies: lies, damned lies and statistics”

-Attributed to Benjamin Disraeli (1804-81), British statesman and Prime Minister (1868, 1874-80), in:
Mark Twain (Samuel Langhorne Clemens), U.S. writer and humorist (1835-1910), Autobiography, “Notes on Innocents Abroad”

In addition, as I mentioned in a comment some time ago, there appears to be a failure to recognize that the regulatory process can only work if there are good
people looking at the matters every day. The regulatory agencies need good people, decently paid, and the dim bulbs at the top of the agencies need to be
replaced with talent.

Posted by Steve | Report as abusive

Mr.Mark, the USA’s Bank’s stress test is a perfect failure and is not in a position to withstand the impact in future.The clouds of recession still hangs over the Stock Exchanges around the world while the green shoots of index level is maintained by the investors for balancing the “foreign exchange rates”. Forget the glimmers of hope, as millions of jobs are lost in every country and Mr. Obama word of economy recovery is “butter over USA”, forcing millions into poverty and starvation. The economy of all countries is like a pack of cards and we the spectators just “speculate”. All the Analyst, economist, market players are now doomed with their own theories or theorems.

Posted by Peter Vaz | Report as abusive


The core of the debate, has been between those who believe that external shock, and too little risk management are the problems, that can be remedied with a little corrective action, and, those who argue that a fundamentally flawed model of accelerating dis-equilibrium has infected the financial system, requiring painfull structural changes.

Recent actions by the Treasury and the fed indicate that fundamental change will not be forthcomming from the Obama adminsitration.

1. The stress tests were not that stressfull. All the SIV’s and many other off-balance sheet Toxicity was not peeked at under the rock’s they lie. The assumptions were mutually agreed upon with the to be tested banks, who vigourusly vetted them, and worse, challanged the results and methodology used.

2. The banks have realised that they have the upper hand in this process. They have openely criticised with impunity, the Treasury for daring to test them. They negotiated easier terms and got almost all their demands. They have cranked up the media blitz on the government with the no nationalization mantra gaining traction on the Talk Radio circuit.

3. The Obama administration is not spoiling for a fight with as powerfull an industry as Wall Street, as it wants to move on with it’s social agenda, and has already signaled capitulation. YOU CANNOT TELL BANKS TO RAISE PRIVATE CAPITAL, THEN SUBSEQUENTLY BREAK THEM UP AS TOO BIG TOO FAIL, or even threaten too.

The banks indicated that they were planning to earn their way out of their holes. CitiBank alone stated it was to earn 80 billion plus over the next two years. How does a crippled bank in a deep economic recession make that kind of Oil company stash. Well by the myriad ways the government has set up to make it happen, from ultra low fed funds rates on loans they flip to us at higher i/r, to back stops on debt, and by buying toxic garbage of their books at above market rates. In other words by letting the Banks grow of the fat of the land until they are healthy again.

The Stress Tests were a time buying manouvere, to try to kick this can down the road until the economy begins to wheeze back to life, and the merry go round could start up again. The Fed, treasury and Banks are intertwined in their fates now. True reform is impossible, as it has been deemed to painfull.

Posted by nyongesa | Report as abusive

This article underscores a consistent theme in this so called “crisis”. Bankers take risk because they want to make money. They want to make money because money is the one resource that will get you everything you materially want and need. Understanding the fact that human beings will work in their own interests first, is it any surprise that the financial system has melted down? Is it any surprise that the reason for the meltdown was systemic fraud based on self interest?

A drug addict will always see their problem in terms of the availability of their drug. If the drug is unavailable everything comes to a grinding halt until a way can be found to get another fix, or the addict is destroyed trying to get it.

I understand that money is important. I think that many Americans understand that money is important. But I also think that many Americans are waking up to the sense that money is just a thing. And if it were managed correctly, it could be helpful to everyone. But the problem is that PEOPLE are in charge of the money system (Treasury/Federal Reserve/Central Banking System), and profit is the only motivator that is acceptable in this society.

What we are facing is ultimately a philosophical choice. If you don’t want to live as a subject of money, then as a group those of us who believe that money should be put in its place need to speak up, and speak clearly. Get rid of human regulators. Money is all about numbers. We have tools that we created specifically to handle numbers in vast quantities. Let’s put these tools to use managing the numbers that we value most right now. Let’s computerize our financial system.

Let all citizens share equally in the GDP of this nation. Give EVERY AMERICAN a financial stake. And let every American decide as a free individual, what goal or set of goals they would like to dedicate themselves to. By removing humans from the financial accounting/banking process, you effectively remove the controls of their interests over you as an individual. Since you would no longer be forced to work for any particular group because you “need the money”, the entire scope of the American social landscape would be shifted such that every individual citizen and every individual vote, would actually count for something.

How would much would that change your life from the way it is now? How would it be if it didn’t matter how much a particular medicine cost? How would it be if you had the means to pay for that special education your child needs? How would it be if you didn’t have to degrade yourself or give up your individual human sense of self every day in order to have what no human being should ever be without?

We are supposed to be a nation in which progress is driven BY economics. Instead our “progress” was simply an effort to drive our economic system for its own sake. If the Treasury, the Federal Reserve, and our Central Banking Systems were automated self sustaining, and free of direct central human control, all fraud would cease. Thus far we as working Americans have been servants of the financial system. We have been called the “backbone” of the American economy.

We are human beings. We are intelligent enough to “fix” this system so that it serves us rather than forcing ourselves to serve it. Our money is fake already anyway. That’s why they can print hundreds of billions of dollars out of thin air. But all the while, you as working citizens are held to account for every penny, even to the loss of your home. If you can’t produce the money to pay your “debt”, why not just ask the government to print some more?

I know it’s not that simple in technical terms. But it is that simple in real terms. Why should you loose your home, or your children do without because money is more important than your value as a human being? It seems ridiculous to me. I wonder if anyone else sees what I see?

Posted by Benny Acosta | Report as abusive

Taxpayers around the world now are either the largest shareholders in these big banks or guaranteeing the asset. So if in the name of transparency this stress test is the best the US government can offer we are indeed back into the dark ages. Taxpayers should be offered total access to these banks accounts so we can make up our own minds, not this bullshit stress test that it the amounts of capital needed seem to change if the banks don’t like the figures they were given. Come on Tim and Ben who are you representing?

Posted by gd | Report as abusive

Q: How does the U.S. government currently stress-test zombies?

A: By how much taxpayer flesh the zombies can eat with nothing in return.

Posted by The Bell | Report as abusive

“bankers and regulators should increase the effective use of risk-management and planning tools in managing bank-related risk.”
How many functions of a bank could work more effectively if the credit issue model, rules and process were “open source”.
How many functions of a bank require a richpigs club and contacts, and the wholesale intimidation and extortion of politicians and taxpayers.
When AIG paid $100Ms of bonuses to “retain the skills” to clean up the hidden mess of unwinding CDSs, one prof said he could do it with his graduate class and some basic office labour.
The US/western financial system has enlarged and turned cancerous and the huge tumor is draining the blood supply, and constricting breathing, and only the rich have pain killers.

Posted by Survivor? | Report as abusive

As long the powerful and corrupt Financial OLIGARCHY is controlling the regulators and the Congress, all the discussions are MOOT!

Posted by SVN | Report as abusive

This economy is going to get worse. That much is certain. Nothing is being done in our interests. Money is being shifted around. “New rules” are being forged but that’s only because most Americans recognize the fact that there are plenty loopholes in our business law. So now they have to make new loopholes we don’t know about, that they can use to suck more money out of the obedient working class.

If you work for a living you are not in control of your life. If you own the resources people need in order to do their work, then you have control over other people to he degree that they need what you own. And those who control wish to retain that control.

We don’t value work and innovation any more. We value money for its own sake. And when you value money for its own sake, the idea of human suffering becomes nothing more than a statistic. And those who actually care about human suffering and speak up on it, are simply ignored or thought of in some negative light.

Keep talking about how to fix this system in the technical sense and you will miss the point of this whole fiasco. Any system that requires that there be human losses in order to work is fundamentally wrong.

Those who ignore this fact do so to their own detriment. The bankers, lawyers, and politicians want you to believe the idea that if they can take your money to fix their systems up again, you can go right back to work for them and continue your happy abusive relationship of living paycheck to paycheck. And maybe you can make enough money to get that HD TV you’ve been eyeing since you lost your job. Maybe that will dull your pain.

If all you want is for this system to be fixed, then you deserve what ever suffering befalls you. It’s not like Americans don’t already know they’re being screwed by the powers that be. But like beaten wives, most of us don’t know anything else, and so we are content to let Wall Street and Washington abuse us, tax us and hurl us into poverty once our usefulness has been extracted.

Posted by Benny Acosta | Report as abusive

There is just one problem with computer controlled financial markets and industries. Humans write the software. On the surface everyone having a stake in the company they work for or institution they bank with sounds good. The privileges and authority of board members would need to be seriously curtailed. I think an analogy to congress is useful here.

Most would agree if all private financing of political campaigns were outlawed then candidates would have to win on the issues not the best fund raising abilities to pay for air time. The hitch is that would not favor the incumbent who usually has the biggest financial war chest. So how do we bring about change. The British passed legislation to ban all corporate and business funding from elections. That, for the United States, would be a huge start. This would greatly limit the influence industries have upon Congress and putting citizens back in Congress’ ear.

The air ways belong to the American People. Television and radio broadcasting companies pay modest licensing fees to provide programing across these airways. In return many of these corporations make millions if not billions of dollars. In the interest of public service, broad casters should be required to provide equal time to any candidate who’s name appears on any election ballot free of charge.

Further the debate organizers should be prohibited from excluding any candidate who’s name appears on a ballot from participating in said debate. Democrats and Republicans have been guilty of this in Presidential debates for decades. Even more sickening is the candidates practice of approving which questions will be allowed to be asked during the debate.

We need something like the “Prime Ministers Questions” in British Parliament all throughout U.S. political discourse. Our leaders need to be put on the hot seat. Particularly the President.

Posted by Anubis | Report as abusive

It’s true that humans write the software. But code can be fixed. Human behavior is impossible to externally control to any meaningful degree.

But if that software were to created to meet specific objectives and nothing more, then it becomes much easier to identify and correct flaws.

Human beings like to hide behind excuses. Wealth allocation and utilization will never be equitable while a few humans control the majority of available resources. Nor will it be equitable while humans control the accounting system.

Money by design was intended to be a universal resource to facilitate REAL resource exchange. This idea was thrown out in favor of a model that uses money as a means of control. If all human beings posses an equal ability to purchase resources, it will be impossible for any one to control anyone else on the basis of denial of resources. This opens a whole new set of social challenges. But it is a much more productive goal for our collective human brilliance than simply figuring out how to stay in survival mode by fixing this outdated economic caste system.

Posted by Benny Acosta | Report as abusive

Just one thing more should happen after your points.
Banker’s income should be decoupled from share value and company’s profits. The remodelling of their income not fully connetced to equity stakes and involved interests, should/could help, in addition to your 4 point remarks, to refocus on recalibrated risk-taking.

Posted by daniele adami | Report as abusive

[…] principles should help reduce the chance of another banking meltdown,” he says in a Reuters […]

Posted by “Stress Tests” Done, Now What? | BU Now | Report as abusive

I hope Tim and Ben once they have retired as public servants don’t take a cent from wall street in “consulting fees” ( or maybe we should call them kickbacks for the trillion dollar handouts at taxpayers expense) Tim and Ben should be forced to sign agreements now that would state they will not make any money in the future due to their present generosity. NOT LIKELY!

Posted by gd | Report as abusive

Gd, your comments speak to my point exactly. These people won’t do what’s right. Either because they have an interest in the way things are, or they just have no idea how to do things differently, or both.
They work in the interests of their own and themselves.

An automated system just allocates money where it’s needed in order to balance everything out. Humans don’t want balance in the true sense. We want power, balanced in our favor. Tim and Ben are living proof. So are Hank Paulson, Allen Greenspan, and Barney Frank. Look at Specter’s naked grab for power by switching to the Democratic party.

Human “leaders” can only be trusted to grab what they can for themselves. And this they will do until there is nothing left to have. Money as a resource was meant to be shared by all and not used as a medium to exert control over others.

There is no other technical fix for this economy unless money is put back in its place, and profit is no longer a motive.

Posted by Benny Acosta | Report as abusive