Missed Opportunity on Stress Tests?

When the Federal Reserve Bank (“FRB” or “Fed”) conducted stress tests of the 19 largest financial institutions back in 2009, many viewed it primarily as an exercise to restore the public’s faith in the financial system. Now that the FRB has requested the financial institutions to perform the same tests again, some are wondering if the tests should be redesigned to be more realistic.  One of those raising questions is Sim Segal, an ERM expert who wrote an article on the subject this week in Forbes magazine. Here’s his view:

….to be meaningful, the Fed stress tests must be changed to include (1) multiple simultaneous risks events, to capture the biggest potential threats, (2) all sources of risk, particularly strategic and operational ones, which represent the bulk of risks, (3) a full quantification of risk exposures, measuring the impact on value rather than on capital, (4) examination of the largest companies in all sectors that can threaten the economy, not just banks, and (5) worst-case scenarios provided by company insiders, to test each firm’s most vulnerable spots.

Mr. Segal raises some very good points that should be considered by not only the FRB and the Financial Stability Oversight Council, but also the individual financial institutions.  For those financial institutions and other companies that are not performing stress tests in the manner suggested by Mr. Segal, it could represent a missed opportunity that could prove fatal.

Assessing Systemic Risk

New York University’s Stern School of Business hosted a conference yesterday to discuss how systemic risk should be addressed under the Dodd-Frank Act.  One of the presenters at the conference, Stanford Finance Professor Darrell Duffie, proposed a new approach for identifying systemic risk.  Here’s some detail on his proposal as reported by Bloomberg.

The world’s largest banks and investment firms should undergo quarterly stress tests to identify risks that could sink the financial system, according to a proposal by Stanford University finance professor Darrell Duffie. “I’m not talking about the ordinary, matter-of-course, risk management of institutions. We’re looking at what are the sources of risk and how are they flowing through the system. We want to connect the dots.”

Duffie calls his plan “10-by-10-by-10” because it’s based on 10 financial firms undergoing 10 stress tests that expose the banks’ 10 largest trading partners. For example, institutions would be tested on their ability to withstand the default of a single firm that they do business with, an idea replicating the 2008 Lehman bankruptcy.

“The objective is to alert regulators and the public to potential sources of financial instability before they reach dangerous levels,” Duffie wrote in a paper outlining the proposal. The tests, which would be adjusted over time to cover different scenarios, could flush out new systemically important firms as they arise, Duffie said. Central bankers could opt to conduct some of the stress tests using average financial numbers over a given timeframe “to mitigate period-end ‘window dressing,’” Duffie said. Regulators should also audit the way the banks measure the data they present, he said.

More specifics about the Duffie proposal are contained in his working paper, “Systemic Risk Exposures: A 10-by-10-by-10 Approach.” By his own admission, Duffie notes that this proposal merely represents a first step for regulators to begin to analyze systemic risk. There are shortcomings to the proposal such as the current lack of data as well as the potential to exclude other entities that may pose risks to the system. However, the regulators must begin somewhere and this approach is a practical method for assessing systemic risk.

Post Stress Test Disorder

Now that the stress tests are over, it looks like the other shoe to drop may be certain changes in leadership at the nation’s largest financial institutions.  According to a report by CNN and Fortune Magazine, regulators are now interested in the ability of bank leaders to properly manage an institution’s risk profile.  Here is what was reported.

The nation’s leading banks may have been deemed solvent, but it remains to be seen whether top management at those firms will soon go bust. Among the findings in its two-month long “stress test” program announced May 7, the government not only told 10 institutions to raise a total of $75 billion in additional capital, but also pushed banks to take a hard look at their leadership. Industry regulators specifically asked banks to review both top executives and board members over the next month “to assure that the leadership of the firm has sufficient expertise and ability to manage the risks presented by the current economic environment.”

Performance to date indicates some institutions have developed “post stress test disorder” and changes may be needed. The only question is whether the changes will be made on their own volition or not.


Mum’s the Word

Reports surfaced today that the U.S. Treasury is delaying the release of the stress test results until after the financial institutions have issued their first quarter earnings reports.  Here is what one report from the Boston Globe had to say.

The U.S. Treasury Department is asking banks not to mention the regulatory “stress tests” as part of their first-quarter earnings results, according to a source familiar with government discussions. Officials are still discussing how to release the results of the stress tests, and the decision will likely be made by the Treasury. The source said officials are aiming to release them in some form at the end of April after the first-quarter bank earnings season is over, and are trying to be sensitive to financial market reaction.

This is a very interesting development that could mean the results are not favorable.  The nature of the results remain to be seen, but one thing is certain – the U.S. Government is exerting a great amount of control over these financial institutions.  


Making the Grade?

During what is spring break for many students across the U.S. this week, some corporate students will be wondering what grade they will receive on their recent tests.  Of course, these students are the nation’s largest banking institutions and they are sweating the results of the “stress tests” that have been conducted over the past month.  While the Federal Reserve and Chairman Bernanke have been steadfast in their views that the tests are not “pass/fail” by nature, the results could prove to be highly impactful to the institutions.  Here is what the Wall Street Journal reported today.

Top federal bank regulators plan to meet early this week to discuss how to analyze the results of stress tests being conducted on the country’s 19 largest banks, people familiar with the matter said. Regulators announced the tests two months ago as part of an effort to determine how much assistance big banks might need to continue lending if the economic downturn worsens. The government is wrestling with how to bolster the lenders without appearing to prop up banks that are beyond repair.  Meanwhile, Treasury Secretary Timothy Geithner said Sunday that the Obama administration would consider removing top management and boards at financial companies if the government were to offer “exceptional” assistance to keep the firms operating.

The next few weeks could be very interesting as the test results shape actions by the regulators.  At the same time, first quarter earnings will be released which could prove to be a “double whammy” for some firms.  

[Timothy Geithner ]

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