Fed Stress Test’s Non-Transparency: Why it Hampers Banks

Newswise — JPMorgan Chase CEO Jamie Dimon, during his bank’s recent quarterly earnings call, criticized the Federal Reserve’s bank stress test as “inconsistent, not transparent and too volatile.” It was a response to results of the latest, annual stress test – the Fed’s response to the 2008 financial crisis to help ensure that large, systemically important banks have sufficient capital buffers to withstand future crises.

But in 2022, the Fed toughened the test’s “hypothetical scenario” to include “a severe global recession with substantial stress in commercial real estate and corporate debt markets.” The Fed further explained: “If a bank does not stay above its capital requirements, it is subject to automatic restrictions on capital distributions and discretionary bonus payments.”

JPMorgan became one of those banks. This year’s test result requires it to hold an additional 0.8 percent of capital. Dimon said this translates to his bank having to keep dividend payments flat, as the Fed has determined that JPMorgan hypothetically would lose roughly $44 billion in a market crash with high unemployment. “There’s almost no chance that that would be true,” he told analysts during the earnings call.

Maryland Smith risk management expert Clifford Rossi, who worked for 23 years in the financial services industry, says Dimon’s contention points to key flaws. First, he explains the process: “Each bank follows a set of prescribed assumptions on key economic variables over such scenarios as GDP, house price growth and interest rates, and runs those through their own financial and risk models over nine quarters into the future. The Fed then runs the results through its own models.”

However, the bank does not get to see the Fed's stress test model (to prevent banks from gaming its models, the Fed says). But the Fed gets to see the bank's models.

“Further, the Fed builds their models based on the data from all the banks being tested and not a specific bank. And this is where things get interesting,” adds Rossi, who has a unique perspective, having led the team that implemented the first version of this stress testing at Citigroup for its Consumer Lending Division.

(Rossi, professor of the practice and executive-in-residence for the University of Maryland’s Robert H. Smith School of Business, leads an expert-panel discussion in a Liquidity and Capital Risk Webinar from 9-10 a.m. Wednesday, July 20.)

“A bank like JPMorgan might have a certain type of portfolio similar to but not exactly the same as other banks, and if the Fed's model says the bank would require more capital for that portfolio than the bank's model suggests, guess what, the bank would need to hold more capital.”

Rossi adds: “So, I do agree with Dimon in that the stress test is not transparent. This makes it difficult for the banks to anticipate the outcome of the stress test. And this is significant given the huge effort that it goes through to develop their estimates.”

But the implications run deeper – especially in a period of the Fed’s quantitative tightening to slow down overheated economic growth and curb inflation. “This can have temporary damaging effects on stock prices for banks failing to meet their stress tests. In the case of JPMorgan, this forces the bank to raise capital and restructure its balance sheet away from certain assets the Fed believes are driving elevated risk at the bank,” Rossi says. “This could, as in the case of their mortgage portfolio, cause them to tighten credit standards and thus reduce the availability of credit to prospective homeowners.”

The underlying purpose of the stress test does have merit, Rossi says. “But the Fed should rely on the bank models with close supervision rather than expend huge amounts of time and resources to build a separate set of its own models.”

Rossi concludes: “Perhaps if the hundreds of PhD economists at the Fed had been used to develop better models of the economy and inflation instead of tinkering with bank models that they had already vetted, we would not have the Fed scrambling to beat back inflation which only months ago had been called transitory by the Fed Chairman.”