Three Common Misconceptions about the Federal Reserve’s Stress Tests

28 Jun 2019

With the release of this year’s stress test results it is important to take a step back and think clearly about what those results tell us about the state of the banking system.  A number of common misconceptions about the stress tests seem to crop up year after year, which makes it all the more difficult to understand the stress tests and what they tell us about the resiliency of the banking sector.  Below, we identify a few of the most common misconceptions and describe why they are wrong.

Misconception #1: The stress tests are a weak test that take it easy on the banks. 

This misconception is surprising given the facts.  Each year, the Federal Reserve releases a “severely adverse” macroeconomic scenario that it uses to independently determine losses on loans, securities and other bank assets.  Each year since 2012 the severely adverse scenario has been significantly more severe than the events of the 2007-2009 recession.  Figure 1 below shows a quantitative measure of stress test severity that was designed by researchers at the Federal Reserve.  The 2007-2009 recession is assumed to have a severity of 100 and values over 100 imply a more severe test.  According to this measure every stress test since 2012 has been more severe than the 2007-2009 recession and the 2019 test is the second most stringent test on record.   

Source: Federal Reserve Stress Test Disclosures: 2012-2019

Further, as shown in Table 1 below, key variables in the 2019 severely adverse scenario are markedly more severe than they were in 2018. 

Table 1: Differences in Stress Scenario Variables: 2018-2019

Scenario Peak to Trough Stress (%)20192018Difference
Unemployment Rate Increase6.25.90.3
U.S. Real GDP Decline8.07.50.5
EU Real GDP Decline5.84.61.2

Source: Federal Reserve Stress Test Disclosures: 2018-2019

As shown in Table 1, the increase in the unemployment rate, the decline in U.S. Real GDP and the decline in EU Real GDP is more severe in 2019 than it was in 2018.  In the case of unemployment, Federal Reserve Vice Chairman for Supervision Randal K. Quarles recently pointed out that “the hypothetical scenario [in 2019] features the largest unemployment rate change to date.”  Accordingly, claims that the stress tests are “weak” and don’t reflect a severe macroeconomic stress are inconsistent with basic facts that are readily apparent and publicly available.   

Misconception #2: The level of capital distributions made by banks following the stress test are destabilizing and bad for the economy.

This misconception is driven by a fundamental confusion between financial resources that leave a bank to be distributed to shareholders and the financial resources that remain within the bank to absorb losses and support resiliency.  Resiliency is determined by the size and composition of financial resources within the bank to absorb losses and not by the amount of resources that are transferred outside the bank to shareholders.  

Dividends and share repurchases represent financial resources that are transferred out of a bank to shareholders.  Shareholders invest their own capital in banks and provide a cushion of support to absorb losses and protect depositors and bondholders in exchange for a share of the firms’ earnings.  Banks (and other companies) that do not reward shareholders for putting their capital at risk will not be able to attract investor capital and will be unable to provide the cushion of protection that makes them resilient in the first place.  This is why all companies everywhere routinely distribute their earnings to shareholders through dividends and repurchases.

It is also important to recognize that capital distributions made to shareholders do not evaporate into thin air but support the economy.  Rather, capital distributions accrue directly to households that own stock and according to the 2016 Survey of Consumer Finances, a majority of U.S. households own stock.  These households then either spend those resources in the economy or the resources are saved, which bolsters household financial security while supporting investment in the U.S. economy.

A bank that is able to make a significant capital distribution to shareholders is a strong bank with levels of equity capital sufficient to withstand significant financial losses while continuing to operate and serve the economy.  In this vein, it is important to realize that all capital distributions made by banks subject to the stress tests are only approved if the resulting capital level that results after distributions are made to shareholders is sufficient to remain adequately capitalized during the stress test.  As such, a significant capital distribution made by a bank should be viewed as a sign of strength and resiliency.

Misconception #3: The stress tests are being watered down to benefit big banks.

This misconception is driven by a simplistic view that “all change is bad.”  The U.S. stress testing regime began over a decade ago in a time and place that is far different from the current position of the U.S. economy.  Since that time regulators, banks and the public have learned a lot about the stress tests and their effects.  And it is incumbent upon regulators to make use of experience and lessons learned to continually improve regulation.  The Federal Reserve, quite rightly, has taken a hard look at the stress testing regime and has identified some key areas where improvements can be made.  One such area relates to transparency.  Transparent stress tests are important so that banks, investors and the public have a clear view of the resiliency standard to which banks are being held.  It is difficult, if not impossible, to engage in meaningful public discourse about the state of the banking system if a key test of capital adequacy is a “black box” that can’t be understood by banks, investors and the broader public.  Transparency is a cornerstone principle of good government that makes as much sense in the context of bank regulation as it does in criminal justice or airline safety.  Recent efforts by the Federal Reserve to improve transparency are important and should be encouraged.

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Forum Statement on Stress Test Results:

Forum members have proven yet again that they can absorb losses and continue to support American businesses, households, and individuals during a time of severe financial stress.  Read our full press release >