Perhaps the single worst idea to emerge from the acute phase of the Great Financial Crisis was the public announcement of the bank stress test results.

Please note, having received training in bank examination while at the Fed, I am a firm believer to do a good job of bank supervision requires stress testing the banks.  So I am definitely not against conducting stress tests.

What I vociferously oppose is the public announcement of the bank stress test results.

Why?

Two reasons.  First, every single time bank supervisors say the banks passed, the bank supervisors create the moral obligation to use taxpayer funds to bailout the banks.

Why is this moral obligation created?

It is reasonable for investors to rely on this public announcement because the investors do not have access to the exposure level data necessary to run their own stress tests on the banks.

Second, by saying the banks pass the stress tests, the bank regulators also make it impossible for the market to exert discipline and restrain risk taking by the banks.

Why does this undermine market discipline?

It is reasonable for investors to rely on the public announcement the banks can survive financial armageddon to conclude banks are taking minimal risk.  Of course, the reality is dramatically different.  As shown by the JP Morgan’s London Whale, the bank regulators have close to no idea what risks are hiding on or off the Too Big to Fail banks’ books.

Of course, all of this is before we get to the Fed officials offering assurances about the financial strength of the banks between stress tests.  The latest example of this was Governor Lael Brainard in her Safeguarding Financial Resilience through the Cycle speech.

What made the speech interesting is first the claim:

Banks are doing well–credit growth is robust, profitability is strong, and capital and liquidity buffers have been fortified.

Then the observation:

Our scan of financial vulnerabilities suggests elevated risks in two areas: asset valuations and business leverage. First, asset valuations across a range of markets remain elevated relative to a variety of historical norms, even after taking into account recent market volatility. …  Second, business leverage outside the financial sector has risen to levels that are high relative to historical trends.

Which raises the question of are banks capable of withstanding the unwind of these elevated risks?

The Governor’s much longer answer can be summarized in one word: yes.

Now, if you are an investor, would you have any reason to think you could lose your investment in any of these banks due to their insolvency?  No.

By the way, this is the classic example of the Confident Idiots at the Fed.  Given the amount of opacity in the global financial system and the complexity of the Too Big to Fail banks, it is more likely than not the elevated risk takes a path no one can predict when they unwind.  And one feature of this path is it will once again call into doubt the solvency of the Too Big to Fail banks. And when their solvency is called into doubt, so too is the Fed as a credible regulator.

Of course, I am not the only one who sees these regulator run bank stress tests as a bad idea.  Larry Summers has weighed in on why stress tests results are not credible.

A stress test that claims that if the Dow falls by 60%, the unemployment rate rises to 12%, housing prices decline substantially more than they did during the 2008 recession, GDP declines by 6-7% — and that all of that can happen and no bank will be in serious financial trouble or have any problem of being undercapitalized or illiquid — I kind of think says more about itself than it says about the health of the banking system.  So I think it would be a mistake to suppose that all is well.

Of course, Professor Summers also shares my opinion and doesn’t think macro-prudential regulation will work.  He notes the success of macro-prudential regulation requires central banks to engage in activities like taking away the punch bowl just as the party gets started that central banks haven’t demonstrated they can do.