The Superfluous Conceit of Mandatory Bank ‘Stress Tests’

In the technology sector, poorly-run businesses don’t last long. They fail quickly only for their assets to be acquired by better stewards. The paradoxical truth is that the technology sector gains strength from periods of weakness.  

It’s something to think about with banking top of mind. Failure in banking has become a dirty word. Unknown is why. Figure that the banking system overall could become sturdier if the weak links in the system were routinely purchased by better managers. But rather than allow market forces to work their magic, regulators continue to pursue “policy” as a way of fighting the very failure that so routinely improves the industries in which it’s allowed.

Take the “stress tests” that regulators at the Fed and other banking industry regulatory bodies routinely call for. Talk about superfluous stab business sans failure. 

That stress tests are superfluous should be one of those blinding glimpses of the obvious. That is so simply because banks, investment banks, and all manner of other financial institutions are routinely conducting these kinds of tests on their own. No force needed. Precisely because tomorrow rarely resembles today, neither do asset prices. Financial institutions logically model all sorts of scenarios (dire, and perhaps not so much) as a way of speculating on how their asset mix would handle the unexpected.  And if financial institutions aren’t conducting these tests on themselves, rest assured those invested in them (and not invested in them) are. 

For regulators to then come in with demands for testing above and beyond what investors and financial institutions are already doing just screams government overreach. As is, banks have a very strong incentive to put a big mirror on their holdings as a hopeful way of protecting against unexpected turns. Second, with regulators it’s not unrealistic to say that we’re talking about people who, by virtue of being regulators, couldn’t get jobs at banks and other financial institutions in the first place. Which hopefully raises obvious questions about why their stress tests would serve any purpose other than regulators essentially engaging in CYA.  

After that, it cannot be stressed enough that there’s an obnoxious conceit to the whole stress testing concept as is. Think about it.  

To presume bank or financial institution soundness based on a “stress test” is to presume bankers or regulators capable of seeing into the future, and having done so, capable of knowing what problems will eventually reveal themselves. Lots of luck there. In other words, if banks knew what stress tests would be relevant to the future, then there would never be bank failures in the first place. 

As evidenced by how much money short sellers can earn when they’re correct, the future is incredibly opaque. Applied to bank stress tests, the failure of banks is invariably a bit of a surprise. If you doubt this, list the investors who were short SVB, Signature Bank and others ahead of their somewhat sudden collapses. Tick tock, tick tock. 

It’s quite simply difficult to see around the corner, which is why hedge funds with a knack for seeing ahead more often than they don’t earn so much money. The future is another country. That it is hopefully awakens readers to the folly of stress tests. While they’re essential as a way of modeling the knowns, markets always and everywhere price the knowns.  

The problem for stress testers is that it’s the unknowns and wholly unexpected situations that ultimately fell financial institutions. Which means the imposition of stress testing as a way of ensuring bank soundness amounts to knowing why a bank will fail ahead of time. Fatal conceit, meet bank stress tests.  

Reprinted from RealClear Markets


  • John Tamny

    John Tamny is a popular speaker and author in the U.S. and around the world. His speech topics include "Government Barriers to Economic Growth," "Why Washington and Wall Street are Better Off Living Apart," and more.

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