As we noted earlier today, the Fed stood fast on the side of securing bank market capitalization when it concluded its stress-test round by allowing limited dividend payments.  This is far from an indefensible stand – see for example Larry Summers’ analysis showing how essential robust market cap is to franchise viability.  It is, however, a deeply unpopular position as well as a dangerous one.  CCAR was already becoming a technocratic exercise in amplifying correlation risk; now, stress testing may have lost all the critical credibility it gained when the 2009 exercise rescued the banking system.  I doubt any dividend payments will scuttle any large U.S. bank, but the Fed has now positioned itself to take the fall should any of them tremble under continuing macroeconomic stress or market fragility.  In 2008, the banking crisis was the banks’ fault; this time, folks will say it’s the Fed’s.

First to CCAR’s credibility gap.  Last night, former FRB Governor Tarullo posted a blistering indictment of the Fed’s actions.  As the uber-authority over the post-crisis rules, this blast might seem like just disgruntlement about changes to his handiwork.  But I think it’s considerably more than that.

When FRB Vice Chairman Quarles announced the 2020 CCAR construct last Friday, he described the COVID-sensitivity test in general terms and then announced not only that its results would be withheld, but also that big-bank performance would be judged by pre-COVID CCAR stresses.  This drew automatic fire on two counts, both of which redoubled in ferocity yesterday because, as Mr. Tarullo lays out, this construct eviscerates the basic goals of U.S. stress testing and why they have been continually more successful than the sham ones undertaken in all too many other nations. 

The first pillar of effective stress testing is rigor.  This was already debatable because, as Mr. Tarullo rightly says, testing was becoming far more of a compliance exercise across the sector than a hard test of individual-bank resilience.  Rigor was particularly absent yesterday when the Fed graded banks on low-stress results no matter the high-stress environment that will actually determine capital adequacy.

The second pillar of stress-test credibility is transparency.  Mr. Quarles did himself and the Fed no favors when he said last week and again on Thursday that the results released by the Fed are translucent.  They are anything but given the obscurity in which markets now find themselves not only about which banks will be able to pay what for the rest of the year, but also and far more importantly about which risks are likely to roil which banks. 

Market discipline now might ensure capital adequacy later, or at least that’s long been the fundamental assumption of stress testing.  If the Fed thinks differently now, it should at least be transparent about that.

What we’re left with is near-term protection for market capitalization at risk of longer-term corrections that, if these come as a surprise to the markets, could pose significant financial-stability risk.  Big banks actually fared remarkably well even under what one is permitted to understand of the COVID-sensitivity stresses.  If the tests are right, then the worst that may be fall big banks is a dip to minimum capital, worst that’s bad but not dangerous to systemic stability or even, in most cases, whatever continuing credit availability is prudent under acute macroeconomic stress. 

The Fed’s reluctance to provide more than general data about big-bank vulnerability may thus support bank share prices, such as they are, but truth might do the same or even better.  If investors knew the truth and the truth weren’t all that awful, they might be willing to give banks still more capital firepower that would then promote economic growth.  That’s what happened in 2009 and it’s even more likely now since banks are significantly safer.

But, what if the Fed’s sensitivity analyses are too gentle and the stresses it has yet to study – i.e., those affecting the commercial real estate sector – prove worse than anticipated?  Banks then might need to reverse projected dividends and surprise financial markets.  That’s not usually a pretty sight and it could be even uglier now.  Is not forewarned also forearmed?