BEWARE THE SILENCE OF THE BANKS / THE WALL STREET JOURNAL

Heard on the Street

Beware the Silence of the Banks

Banks are complaining about the opacity of Federal Reserve ‘stress tests.’ Understandable, yes; so, too, is the reason the Fed needs to keep them that way

By David Reilly

March 15, 2015 6:36 p.m. ET

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Banks last week complained they have too little visibility into how the Federal Reserve calculates the results of its “stress tests.” Photo: Bloomberg News 

 

 

The banks doth protest too much. As if on cue, banks last week quickly bemoaned the Federal Reserve’s “stress tests” soon after capital-return verdicts based on them were released. Their lament: They have too little visibility into how the Fed calculates results and ensuing decisions on capital-return plans. The process is a black box, they say.

It is. And so it should be.

The point of the tests is to gauge whether banks are in fine-enough fettle to weather the next financial crisis, should one erupt. And, as was the case last time, what causes the next blowup will likely catch most of the world unaware.

Given that, the tests should be unpredictable. And they need be constructed with an eye to the fact that banks will try to game them. That is human nature, especially when big bonuses are at stake.
Given that, banks’ interest in criticizing the process is germane. The tests determine how much capital banks can return to investors, influencing returns on equity.

 

Both are vital to shareholders, especially as superlow interest rates have cut bank earnings and crimped returns on equity. In 2014’s fourth quarter, these averaged 8.5% for big banks, according to Federal Deposit Insurance Corp. data, more than two percentage points below the 20-year average.

Bank executives will understandably argue for a process that helps them on this front, rather than one offering uncertain outcomes.

Yet the Fed rightfully has different concerns. It has to consider the interests of taxpayers as well as the strength of the financial system. On that score, it is better if the Fed keeps banks guessing on the tests, and so insures firms remain more resilient.

And while J.P. Morgan Chase, Goldman Sachs Group and Morgan Stanley had to revise down the amount of capital return they sought, they still were able to send more money back to shareholders.

Nor should the fact banks had to change their requests be seen as a negative thing. It shows they weren’t being overly conservative. And banks asked for the ability to take such “mulligans” in the first place. Bankers and shareholders always will gripe about the test process. Those concerned with financial stability should worry the day that stops.