There's One Big Problem With the Fed's Latest Stress Test

The Federal Reserve released its latest stress test report in June and buried within the findings were details that an alarming number of banks would lose tens of billions within the financial system yet again.

Nearly a decade since the global financial crisis that saw countless jobs, homes and savings ruined — signs show that the system is still considerably at risk.

By mandate the Fed is to be a central banking institution that encourages and sets conditions for secure banking and financial systems to exist.  At its core, the central bank is meant to stabilize and grow the economy through measures such as supervising what it has labeled as banking holding companies (BHCs).

After the Dodd-Frank Act was passed in 2010, the Fed took on the responsibility to conduct stress test reports on financial firms, the select BHC’s, that maintained $50 billion plus in consolidated assets. The purpose was to see if those firms had enough money saved and whether they would be able to meet required financial levels in order to survive massive losses during stressful economic conditions.

Within its latest model, the Federal Reserve projected that an estimated 34 banks would “experience significant losses on positions and loans under the severely adverse scenario.”

The report summarized that losses could hit an estimated $493 billion across loans, credit on securities, trading and a range of other provisional outlets. In the chart below, the near half a trillion in losses would hit almost every sector in the financial industry.

[The Federal Reserve System: Dodd-Frank Act Stress Test 2017: Supervisory Stress Test Methodology and Results]

Though the major Wall Street banks may have passed the Fed’s Comprehensive Capital Analysis and Review (CCAR), the threat of too big to fail continues to rise.

All of this while Wall Street banks are pushing to slash financial regulations further and elevate the risks held by the biggest banks, ultimately continuing to put the global economy on course for disaster.

At one point in time, banks were a means to lend money to businesses and individuals that had wanted to create jobs, products and services. To put it simply, banking was a way to expand the U.S economy and to promote innovation.

Since then, Wall Street has taken the ability to make high risks, high rewards into a speculative free-for-all culture.  This highjacking put incredibly negligent bets above logical rationale.

The Fed: A Stress Test of Too Big to Fail

What the Fed has done is not only allow for such risks to continue, it has institutionalized a system where risk is subsidized by the government with bailouts and cash injected spending programs.

By allowing derivative exposures to rise higher than they were in 2008, the Federal Reserve has allowed too big to fail to be propped up once again.  The major risk is that this time the exposure, complexity and risk is even higher — and the fall will be even more dangerous.

Jim Rickards served as general council for Long Term Capital Management (LTCM) when it needed to be bailed out in 1998. The hedge fund operated on high stakes financial leveraging and lost it all. LTCM required billions of dollars in “recapitalization” with guidance from the Fed.

Rickards’ knows better than most and now warns that the circumstances in the financial system are at levels not seen in recent memory.  Speaking on the global financial crisis in 2008 he recalls, “Derivatives were hidden off balance sheets by the banks, and price information was not publicly available but confined to a relatively small number of bank dealers.”

“Derivatives also involved embedded leverage. Regulators did not require sufficient capital to cover their risks.”

“Since 2008, some improvements in derivatives risk management have been made, including centralized clearinghouses, higher capital requirements and limits on proprietary trading imposed by the Volcker Rule.”

The best-selling author, while speaking reluctantly on the rules in place, noted that there is a critical need to break up the big banks and warned, “regulators are like generals fighting the last war.”

While it is true that the Federal Deposit Insurance Corporation (FDIC) has made considerable reductions on the amount of institutions on its “Problem Bank List” the threat has not vanished.

As of the end of March, the FDIC only has $84.9 billion in reported funding to bailout any deposits by selected banks that might collapse under stress.  That number is also significantly less than the risk that could be leveled in a systemic financial shock.

This comes at a time when Fed leaders continue to push a narrative that disconnects from the reality of the financial holdings.

While speaking in London, Fed Chairman Janet Yellen began pedaling that the Fed was well equipped to handle such adversity.

Yellen noted that the U.S central bank has “been very focused on making sure the core of our financial system has enough capital so they will be able to go on lending and supply credit to the economy even in a major shock…”

While financial media may have focused on Yellen’s negligence in statements about another financial crisis, the real story is that she believes the stress test systems are providing sufficient safety nets.

The credit and credibility of the financial system, watched by the Fed, has allowed risk and too big to fail to return.

Nomi Prins, a former Managing Director at firms such as Goldman Sachs and Lehman Brothers offers her final analysis from the deteriorating situation.

“Sadly, the rush to bigness that was blessed by the Fed and the prevailing idea that you have to save, and even grow, giant firms imply that no real lessons were learned. The way to avert a credit crisis is to regulate its source, to take away the ability for the financial system to leverage and trade itself beyond its capacity to absorb the risk that it will incur — and that will harm the entire economy.”

Prins’ urges, “We cannot continue to let any financial institution become too big and complicated for the government to understand, particularly when the government is expected to save it from demise.”

The Fed’s stress test, while not the single solution, shows that the risks on Wall Street of too big to fail have not vanished. Under current threat of another financial crisis, accountability and sustainable solutions must be front and center.

Thanks for reading,
Craig Wilson, @craig_wilson7
for the Daily Reckoning