As I was increasingly buried by the avalanche of proposals weighing in at hundreds of pages in 2011, I argued desperately that regulators should focus on two critical factors: simplicity and accountability. Thousands of pages later, the FRB’s new supervisory standards for its BHC stress tests are strikingly clear and decisive. For the first time I’ve seen, the Federal Reserve has required techies not just to run models upside-down and backward, but also to come up with results that are, as the Fed says, “economically intuitive.” That is, if it looks wrong to an informed director or senior manager, it should be treated as wrong. If it looks wrong and the board or senior management looks the other way, then they’re wrong and will be held accountable, or at least so the Fed says. Mirabile dictu.
If the Fed’s approach to stress testing works as hoped – over to you, FRB – it will combine the complexity required at diversified, sophisticated banks with the touchstones needed for effective governance and supervision. Model-builders are to erect their hanging gardens for the bank’s flora and fauna, but then common-sense architecture discipline is to take over so that outsiders to the model’s seemingly-wondrous engineering can determine not just if it’s pretty, but also if it works from a common sense perspective. If one can only see the hydrangeas by standing on one foot off a parapet, the bank flunks the stress test.
Put another way, if a bank wants to go deep into no-doc mortgages to “seasonally”-employed borrowers at a 120% loan-to-value ratio, it doesn’t matter that the bank thinks it’s taking no risk because the loan will be securitized or, if it holds the MBS, God has granted it a AAA. Think about it – in 2006, these mortgages yielded less than a Treasury bill and yet fancy models said all this made sense. Now, if the models still say so, someone is to administer the dope-slap. And, if he or she doesn’t, then senior management and/or the board will, the FRB promises, be held to account.
One other very good thing about the new FRB guidance is that it takes stress tests off the credit-risk monorail. I have criticized these exercises on grounds that big banks fail for reasons that have nothing to do with credit risk. Even after the Board recognized this for the very biggest banks and added a market-risk component to the stress tests, the exercises still omitted risks that have not only cost banks big, but also led to failure and even systemic risk. Many of these other risks – operational, reputational, strategic, compliance – are hard to quantify. Indeed, if one gives it a go, results are often perverse (see, for example, efforts to model the risk of terrorist attack). In this supervisory statement, the Fed acknowledges the vagaries of untested models for idiosyncratic risk and, while it doesn’t withdraw from the capital charge based on these same operational-risk models as it should, it at least says that stress tests should make sense from a qualitative and, yes, intuitive perspective no matter what the models may or may not say.
Will big BHCs like the new approach to stress tests? Not one bit, I’d bet. It’s hard in many respects, not just because boards and senior management have to leave the comfy zone in which they get to do what power-points with lots of numbers tell them. The Fed has also said that even trusting it won’t ensure a passing grade – BHCs can’t just add a buffer to Fed-stipulated adverse results to be sure they’re secure from stress. Further, hopes like management’s ability to act fast can no longer be counted upon to conquer realities like barriers to doing so as markets collapse. In all likelihood, big BHCs will need to add still more capital, although for the first time the standards – right-on – say that risk can also be absorbed by altered revenue expectations, improved risk management and revised strategy (i.e., don’t do the dumb deal).
Stepping back from the cost of the stress tests the industry should bless the keyboards on which the new standards were crafted. The Fed is telling BHCs to have their capital make sense not just to algorithms, but also to sensible people exercising reasonable judgment. If this keeps up, maybe a lot of punitive, arbitrary rules will get another look.