Federal

The Federal Reserve Bank of New York.

Part of the government's response to the financial crisis was to implement a system of required stress tests for major U.S. banks.

Banks with total assets in excess of $50 billion are required to conduct their own in-house stress tests, which the Federal Reserve reviews and gives the banks a pass or fail. The Fed also conducts its own independent stress testing of the banks' balance sheets.

In theory, the two sets of stress tests are a thorough, systematic way to manage systemic risk and avoid a repeat of 2008.

Last week, the Fed released a list of issues with the internal stress tests conducted by banks in the form of expectations for the 2015 round of tests. Perhaps unsurprisingly, the regulators found plenty of issues across the board.

Unsubstantiated assumptions
At its heart, these stress tests seek to take a bank's financial statements and project net income, capital, and loan losses under a varying set of economic conditions.

For traditional bank businesses such as making loans, the stress tests assume a sudden spike in unemployment, rapid changes in interest rates, or an abrupt decrease in GDP. For banks with higher exposure to trading and market positions, the tests assume a drop in the stock market upward of 50% or more and other market-related changes associated with a crisis or recession. In these extreme, adverse cases, the objective is to ensure that the banks have the capital and the stability to withstand these shocks without the need for a bailout, or worse.

To effectively run these tests and get accurate results, banks must make assumptions about their investments, their portfolios, their loans, and the markets. The hope, of course, is that these assumptions are conservative, and really do find any weaknesses so that they can be corrected.

Unfortunately, the Federal Reserve reports that banks are not doing a good enough job in the assumptions they use in their stress tests. The Fed called the banks' financial projection models "weak or poorly specified." The assumptions were poorly documented or supported, and oftentimes assumptions were made seemingly arbitrarily, without justification that they were reasonable.

Banks it seems are approaching the stress tests as a chore to be completed, instead of a necessary procedure to improve.

Banks are still arrogant
The Fed also pointed to an overuse of management defined qualitative estimations overriding quantitative assessments made from analytical methods.

Wall

This means that when one of the banks' projection models spits out a bad result, bank management tends to override that result and make a more positive conclusion. 

The Fed writes:

[Banks] should also not assume any foresight of scenario conditions over the projection horizon beyond what would reasonably be knowable in real-life situations. For example, some [banks] have used the path of stress scenario variables to make optimistic assumptions about possible management actions ex ante in anticipation of stressful conditions, such as pre-emptively rebalancing their portfolios or otherwise adjusting their risk profiles to mitigate the expected impact. In the event of a downturn, the future path or progression of economic and market conditions would not be clearly known, and this uncertainty should be reflected in the capital plans.

It sounds like the so-called "smartest guys in the room" are also the "most arrogant guys in the room." No one -- repeat, no one -- can accurately predict where the economy or market is going at a macro level. If 2008 taught us anything, it's that banks can be blindsided just as easily as the rest of us.

And yet, the Fed is telling us that bank management not only thinks they can see into the future, but also thinks they'll be able to protect the bank from those adverse changes before they happen.

It's worth noting that the Fed included that statement in section titled "Conservatism and Credibility." Reading between the lines, it seems the emphasis is on credibility.

Foolish takeaway
Despite the room for improvement, banks are getting better at these stress tests, and the reality is that they must get better.

Last year, both Citigroup (NYSE:C) and Bank of America (NYSE:BAC) were forced to put large share buy backs and dividend increases on hold after shortcomings in their stress test performances. That's billions of dollars that could have been returned to shareholders, but instead sits idly in the bank's coffers.

Fdr Signign Bank Act

FDR signing the Bank Act of 1933. The financial system has come a long way since the Great Depression, but there is still room for improvement.

Even more significant though are the implications for the stability of the financial system. These stress tests are in place not to hinder profits or limit growth. They are the centerpiece of the government's attempt to bring stability to a financial world dominated by a handful of truly massive institutions. Don't forget, these tests are only applicable to about 30 institutions, and these banks are called "too big to fail" for a reason.

The financial crisis began about seven years ago. Today is a critical moment for the financial system, banks, and investors. Will we remember the lessons learned, or will complacency and arrogance lead us toward another crisis?

 

Jay Jenkins has no position in any stocks mentioned. The Motley Fool recommends Bank of America and owns shares of Bank of America and Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.