Fed’s stress tests were a confidence-rattling comedy of errors

April 28, 2014
April 28, 2014

Bank stress tests are supposed to offer a shot of confidence in the financial sector.

But the most recent tests of capital levels at US banks has been more of a series of mishaps and miscues. They’ve only served to highlight how difficult it is to both run and oversee the world’s biggest financial institutions.

The latest example is Bank of America. Today the bank announced that it discovered an error in the way it accounted for the certain assets that were a part of its 2009 crisis-era acquisition of Merrill Lynch. As a result of the error, the firm is halting a planned $4 billion stock buyback as well as a dividend boost.

Nobody looks good here. The fact that Bank of America’s chief financial officer Bruce Thomson didn’t catch the accounting problem isn’t great. (Three other CFOs before him also missed it.) And the fact that the Fed didn’t catch the mistake either shows just how just how dependent government regulators are on what the banks disclose to them. It means that the bank has been operating with around $4 billion less capital over the last few years than it has been telling investors, the New York Times reports.

In fact, besides the Bank of America mess, the Fed itself revised its initial assessment of the health of 15 banks last month, just one day after it officially came out with the results of its stress tests. It cited “inconsistencies” in the way the tests were administered. The central bank said it’s reviewing (paywall) its stress-test process.

And don’t forget about Citigroup. The Fed slapped down Citigroup’s plans to return capital to shareholders, after Fed regulators noted “a number of deficiencies in its capital planning practices.”

What’s going on here? Well, one lesson to take away is that accounting is difficult, detail-oriented and subject to interpretation. But that’s not at all new.

The other lesson might well be that this is precisely why it’s better to ask large, complicated banks to operate with much more capital than they would strictly need on any run-of-the-mill day. (Operating with large amounts of capital basically means a bank is borrowing less, and using more of its own—and shareholder—money to finance its activities.)

Some academics have argued that forcing banks to operate with less debt—that is, with more capital—makes the financial system less susceptible to crises.

And since it’s too difficult to get into the details on how much capital banks actually have—Bank of America itself didn’t know for the last four years!—the best policy is simply to require them to have more than enough. That’s especially important with a system where a mere accounting error can instantly vaporize billions in capital. Announcements like Bank of America’s this morning make that argument look pretty sensible.

 

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