Regulators have made it easier for banks to pass on their so-called stress test. While this could be good for investors, some industry observers worry that it opens the door to another financial crisis.
After the market closes for the week, the Federal Reserve releases the first half of the bank's stress test results designed to see how banks would go in the event of a serious economic downturn.
Banks are generally expected to pass, which is likely to increase bank deposits and boost the new heights that the market has hit. "For banks that no longer have to test every year, there should be some cost savings. The test this year should also be a little easier so you can see increases in return on investment," says Eric Compton, an analyst at Morningstar. "All in all, there still seems to be a bit of extra capital to release, which should improve the results a little."
During President Donald Trump's appointed Randal Quarles, the Federal Reserve has given some banks more time between trials and has provided them with more information on the modeling to calculate how a bank would fare in a "seriously negative" economic climate where unemployment rose. 1
Experts said some changes in the parameters of the stress tests that the financial industry has complained about since they were implemented in the wake of the financial crisis were justified. And next year, the Fed will add an additional item that may require banks to retain more reserves based on hypothetical risk modeling scenarios.
Bank analyst Bert Ely said that this new requirement could create market distortion. "The Fed can release unintended consequences," he told NBC News. "The underlying problem with all one-size-must-fit-all banking rules [is that] doesn't suit them well. The Fed staff are trying to adapt to this problem through their often fuzzy forecasts of what the future can hold," he said.
Bank experts agree that the problem is that no one can predict the future – but they disagree on how to measure and mitigate this risk in today's economy. "The concern should be how well and how aggressively the big banks respond to changes in the risk environment," Ely said.
"The problems that created the problem 10 years ago – it's a pretty different world today," said Charles Elson, director of the Weinberg Center for Corporate Governance at Delaware University. "Changing the stress test doesn't mean we're in a financial crisis," he pointed out.
"The problem in the financial crisis was that the banks did not have sufficient capital as the loans started to go bad at a pace," said Greg McBride, financial analyst at Bankrate.com. Today it is not the case, he said. Banks are safer than they were before the crisis and are better capitalized than their foreign competitors. "The changes in the scenarios really only correspond to everyone a tweaking. It doesn't take us back to the Wild, Wild West of 2007," McBride said. "There is some kind of knee war reaction after a crisis to introduce standards that go beyond what is needed and then over time the pendulum sets in the middle."
But some worried concerns that relaxing stress test requirements could end up masking risk in a not yet known aspect of the banking business. "Exception of the smaller banks made sense, but it is crucial that regulators continue to demand that big banks prepare for bad times and unpleasant surprises – and stress tests are perhaps the best way to achieve that goal," David said. Wessel, Director of the Hutchins Center for Fiscal and Monetary Policies at the Brookings Institution.
In particular, losing the requirement for banks to pass a qualitative test of their internal data analyzes and practices could leave blind spots. "I'm concerned about the decision to delete the qualitative assessment," said Karen Shaw Petrou, executive partner of the Federal Financial Analytics consulting firm. "We've learned for many times the hard way models are based on retrospective assumptions," she said – assumptions that can be exploited by poor management or more risky returns.
"The stress tests, undoubtedly a hassle for the banks, play an extremely important role in reducing the chances of us suffering a recurrence of the global financial crisis," says Wessel.