NEWS RELEASE: Federal Reserve Stress Test Results Highlight Failures of the Stress Testing Framework

Today, the Federal Reserve is releasing the results of its 2020 bank stress tests. Incredibly, the Fed has chosen to permit banks to continue to pay dividends based on past earnings, rather than restricting capital distributions based on realistic estimates of the downside risks of the current recession. Instead of providing a realistic assessment of the solvency and capital position of individual banks, today’s release highlights the failures and politicization of the stress testing program and its inability to ensure capital adequacy.

For years, the Federal Reserve has systematically weakened stress test modeling practices and assumptions used to forecast bank losses in a recession. This has the effect of allowing banks to reduce their reserves of risk-reducing capital and distribute these reserves to shareholders and executives. As AFR has documented, in 2018 and 2019 the Fed permitted banks to draw down capital reserves by paying out a record $265 billion in capital distributions, more than 100% of their net revenues.

Now, the reality of a major recession has made this practice unsustainable. The stress test models published in February, 2020 were based on assumptions and led to loss estimates that are obviously inadequate and far too weak to reflect the current economic situation. Because of this, the Fed has also added ad hoc sensitivity analyses involving various Coronavirus risk scenarios to the stress testing process. These are included in today’s stress test release.

But incredibly, these more demanding and realistic estimates will apparently not be used to determine any capital requirements for individual banks. Instead of requiring banks to reserve capital to support critical financial services through what could be an extended recession, the Fed will apparently continue its current policy of permitting banks to pay out dividends even in the midst of an economic crisis of unknown duration.

The experience of the past decade should lead policymakers to reconsider the wisdom of basing critical bank risk controls like capital requirements on an opaque and technocratic stress testing process subject to political manipulation. Instead, we need strong basic requirements that will ensure the soundness of banks through even a significant recession.