Bank stress tests: How much should be revealed?

From: Blog

The US Federal Reserve has just announced results of the first of two banking stress tests, which are supposed to tell regulators if large bank holding companies have enough capital to survive another economic downturn. The results suggest that, in the aggregate, the 30 bank holding companies would suffer big losses.

The 2010 Dodd-Frank Act mandated bank stress tests, but didn’t specify how detailed the results should be (or if they should be bank-specific). In a forthcoming research paper, Haresh Sapra, professor of accounting at Chicago Booth, and his colleague Itay Goldstein of the University of Pennsylvania discuss the pros and cons of full disclosure. Market discipline should improve if stress-test results provide insight about a bank’s ability to withstand market shocks.

“Public disclosure of a bank’s financial condition enables market participants to make informed decisions about the bank and such informed decisions, in turn, discipline the bank’s actions,” Sapra and Goldstein note. However, bank-specific disclosures may encourage bankers to game the process by dressing up their balance sheets. That might get them a passing grade, but reduce long-term shareholder value.

Stress tests provide more information to regulators, allowing them to better monitor banks and intervene earlier to recapitalize weak or insolvent banks. Regulators intervened late during the last crisis and panic ensued when it was difficult to distinguish a solvent bank from an insolvent one. That damaged regulators’ credibility. It might be improved by disclosing the stress test methodology as well as its results.

Sapra and Goldstein worry, though, about the unintended consequences of full disclosure. If tests are not properly designed, markets could panic. Stress tests have two implied goals that may be incompatible. The microprudential goal is met if regulators can be sure an individual bank has sufficient capital to absorb potential losses and remain solvent. The macroprudential goal is met when we’re reassured the banking sector can survive a systemic crisis, even if the survival of any one institution is not necessarily guaranteed.

The stress test disclosure debate has been dominated by the goal of improved market discipline without considering potential downsides, Sapra and Goldstein argue. To address the issue, they make several policy recommendations. First, test models should not be disclosed so banks can’t “study to the test.” Secondly, test disclosures should include detailed information about the risk exposures of each bank by asset class, country, and maturity, so the market can evaluate whether the bank engaged in sub-optimal behavior to pass the test.

Disclosure of aggregate results instead of bank-specific results promotes risk-sharing activities in the interbank market, reduces bankers’ incentives to take undesirable short-term actions, minimizes the possibility of the “self-fulfilling prophecy effect” of a warning, and maintains regulators’ ability to glean the information they need.

But if the goal is to protect investors and other stakeholders and promote the stability of individual banks, individual results have to be disclosed, even if regulators try to limit their unintended consequences.

The Fed returns on March 26 with results from part two, an exercise it says should “ensure that institutions have robust, forward looking capital planning processes that account for their unique risks and sufficient capital to continue operations throughout times of economic and financial stress.”

We can only hope.
—Francine McKenna 
Cat:Markets,Sub:Finance, Accounting,


Is Capitol Hill reading Capital Ideas?

From: Blog

A sudden frenzy of financial reform efforts follows our magazine relaunch

It’s been five years since the financial crisis, and depending on who you listen to, the US has either come a long way since or made pitifully little progress in reforming the system. 

Barack Obama, for example, told a crowd in Galesburg, Illinois, last week that in the past half-decade, “Together, we put in place tough new rules on the big banks, and protections to crack down on the worst practices of mortgage lenders and credit card companies.”

For a different view, see our recent mini-documentary in which Booth faculty John Cochrane, Anil Kashyap, Douglas Diamond, Randall Kroszner, and Luigi Zingales outline how little has changed, and how the fundamental problems—of the fragility of our run-prone banking system—remain in place.

The documentary, which is a companion to the cover story from the Summer 2013 edition of Capital Ideas magazine, outlines four basic ideas for fixing the system:

•    Break up the big banks;
•    Hike capital requirements;
•    Improve regulation; and
•    Establish a global resolution authority.

Remarkably, in the two months since the relaunched magazine was published, there has been a frenzy of activity on these very fronts. 

Big banks would be broken up, under a proposal introduced this month by four US Senators—Elizabeth Warren of Massachusetts, John McCain of Arizona, Maria Cantwell of Washington, and Angus King from Maine. Their “21st Century Glass-Steagall Act” would separate commercial and investment banking. "Big Wall Street institutions should be free to engage in transactions with significant risk, but not with federally insured deposits,” noted McCain, a longtime supporter of the idea.

Capital requirements look set to rise significantly, after the Federal Reserve said it would go beyond the ratios set in the Basel III accords, making banks not only comply with rules on equity to assets weighted for risk, but also to adopt additional leverage requirements relating equity to overall assets, regardless of risk.

There are also signs that regulators are starting to co-operate on the details of overseeing the global banks. After months of difficult negotiations, the Commodity Futures Trading Commission (CFTC), the US’s derivatives watchdog, and the European Commission struck a deal this month to work together on regulating financial transactions that could present systemic risks. To its credit, the CFTC dropped its insistence that it have jurisdiction over all US-based banks or ban them from conducting business abroad. They will now be able to do so as long as European regulations are “essentially identical” with those in the US.

We would never suggest, of course that Capital Ideas alone prompted these initiatives. But you have to admit, our timing was pretty good. Just another reason to keep following us on www.ChicagoBooth.edu/capideas.

—Hal Weitzman

TAGS: policy, finance, economics, regulation, banking, John Cochrane, Anil Kashyap, Douglas Diamond, Randall Kroszner, Luigi Zingales, Federal Reserve, Commodity Futures Trading Commission

Cat:Policy, Cat:Markets, Sub:Economics, Sub:Finance,