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Has the Fed gone too far on bank stress tests?

August 20, 2013: 5:00 AM ET

The Federal Reserve sheds some light on why Goldman and JPMorgan got a conditional pass on this year's stress tests, but the 41-page report is overkill.

Goldman Sachs headquarters

Goldman Sachs headquarters

FORTUNE -- The Federal Reserve won't rest until the nation's biggest banks are 100% safe, which means, basically, the Fed won't rest.

On Monday, the Fed released a report assessing how well the banks have done in the past year or so planning for another financial crisis. The Fed's assessment: So-so.

The regulator found that bank executives do think a lot more about how much money they need to cover potential losses, but there are still major holes in the tests they use to determine whether that will be enough. And the first bit is weak praise. Pretty much everyone agrees they did a terrible job of so-called capital planning before the financial crisis. That is, after all, one of the reasons we had a financial crisis.

The report has to do with the Fed's annual bank stress tests, which some have complained are too easy. This year, as in past years, nearly all of the nation's largest banks passed, meaning the Fed believed they had enough resources on hand to weather another economic downturn. But the Fed said it had some concerns about Goldman Sachs (GS) and JPMorgan Chase (JPM), but didn't say what those were. Both banks were required to resubmit their capital plans by the end of September.

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No bank was mentioned by name in Monday's 41-page report. But the Fed did give some clues as to why Goldman and JPMorgan might have been given incompletes. The Fed faulted some banks for relying too heavily on credit ratings, which were shown during the financial crisis to be almost useless, particularly for so-called structured products like collateralized debt obligations. It also said some banks weren't realistic about whether they would be really able to raise capital or sell troubled assets during a financial crisis. In late 2008 and 2009, they weren't. The Fed also said some banks based their capital goals on the absolute minimums required by law. The Fed apparently wanted them to shoot higher. And it said a number of banks relied too much on what has happened in the past, not what might happen in the future.

Apparently, in a number of instances on the stress test, banks just repeated the expectations that the Fed had laid out without citing specific examples for their bank. The Fed can see through your clever rewording, and doesn't like it. And some banks used external data that didn't take into account concentrations in a particular line of business or area of the world.

Throughout the report, the Fed seems to say again and again that the banks didn't customize the stress test enough for their own situations. But that seems like a weird critique. The stress tests are set up based on three specific economic scenarios. And they are the same for all the banks. The Fed has said in the past using the same scenarios industrywide helps regulators better assess the individual results of each bank. Now it seems to be saying the opposite.

Then there is this:

The size of shocks assumed in the stress scenario is often quite large. As a result, mechanical application of such shocks to current levels of risk factors could result in implausible outcomes such as negative risk free rates or negative forward rates. BHCs [bank holding companies] should ensure that the proposed shocks produce results that are plausible.

But the economic scenarios that the Fed proposes -- unemployment hits 12% by the beginning of next year -- are implausible. So it seems reasonable that the banks would come out with some outcomes that are equally implausible.

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The report also says that a number of banks failed to point out the "limitations" of the estimates they provided the Fed. But what Wall Streeter is good at pointing out his or her limitations? And we all have limitations in estimating worst-case scenarios, precisely because it is hard to imagine worst-case scenarios.

In the end, the Fed's report is overkill, and a little silly. Am I prepared for what would happen if a hurricane blew away my house or flooded it? Not really. I have insurance. But I don't know where I would sleep or have copies of whatever is in that catch-all folder in my home office labeled "important documents."

Banks, like all of us, are only so good at preparing for the unknown. But at a time when banks are saying, through highly-paid lobbyists and regulator-turned-consultants-for-hire, that the Fed is requiring them to hold too much capital, it's helpful to have 41-page documents that say in great detail that banks still don't know what they are talking about.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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