The Fed’s Stress Tests: Too Little, Too Late

The Federal Reserve has set the rules for its Comprehensive Capital Analysis and Review for 2012. The stress test will be based on extremely harsh economic conditions. For America’s largest financial firms, the test will be even more severe. The Fed’s decision is founded on fear that the EU financial trouble could spread and that the U.S. economy could go into another deep recession. Given the level of trouble the Fed has decided to test for, it is odd that it does not conduct the tests more often.

The tests for the big banks will be unusually comprehensive:

In addition to the macroeconomic scenario provided by the Federal Reserve, the six largest firms will be required to estimate potential losses stemming from a hypothetical global market shock. The global market shock will be based on market price movements seen during the second half of 2008, a time of significant volatility, with adjustments made to incorporate potential sharp market price movements in European sovereign and financial sectors.

Part of the macroecnomic “scenario” is that unemployment could reach 13% by early 2013. That is higher than it has been in any recession since the Great Depression. That makes the anticipated conditions very unlikely, but the Fed does not want to appear too soft, particularly if the financial world falls apart. And, it may. Increasingly, analysts say U.S. banks have more exposure to Europe than they admit. Those same banks have made few decisions to weather a storm similar to that of the credit crisis in 2008.

The stock market has become as worried about America’s largest banks as the Fed is. Bank of America (NYSE: BAC) and Morgan Stanley (NYSE: MS) trade at levels last hit in March 2009, the depth of the stock market sell-off. The trading is anticipatory, and it may be based on correct evaluations of the problem, which shows signs of getting much worse, as it did three years ago.

The Fed will not start its tests until early next year. The results will not be available until after that. A financial catastrophe may have begun by then. If so, the test will have been well-intentioned but tardy.

Banks must collect huge amounts of data when they report quarterly results. Auditors comb balance sheets. However, banks do not present all of the information that their in-house financial staff and auditors mass. They should present it to the Fed each quarter, though, and stress test measures should be applied — every quarter, without exception.

The Federal Reserve has taken the right course as it prepares for a new series of stress tests. It should just do them more often. It is easier to see trouble coming that way.

Douglas A. McIntyre