The Fed released the results of its annual stress tests and the question was why were JPMorgan and Goldman so close to not passing. The simple answer is “in the presence of opacity, the banks are gaming the stress tests”.
The stress test results are released in two parts. The first part is a release that always says the banks are adequately capitalized to survive even the worst financial catastrophe. The second part is a determination of how much “excess” capital the banks have above what they need to survive the worst financial catastrophe. It is this capital the banks can return to shareholders.
The reason JPMorgan and Goldman were close to failing was in the second part of the test they tried to push the issue of how much capital they could return.
In the presence of opacity, both the banks and the Fed can game the tests. This can be easily shown by looking at the results of the latest test. Look who appears to be a model bank: Citi. Yes, the very same bank that has been at the forefront of every financial crisis (think Less Developed Country debt crisis and our recent subprime mortgage crisis for example). In addition, Citi was recently cited for having the worst living will among the big banks.
The only way to end both the banks and the Fed gaming the stress tests is if the banks provide the transparency necessary to qualify for a label from the Transparency Label Initiative<sup>tm</sup>. With this level of transparency, market participants can exert discipline so neither the banks nor the Fed game the stress tests.