Three Federal Studies Show Fed’s Stress Tests of Big Banks Are Just a Placebo

By Pam Martens and Russ Martens and cross-posted from Wall Street on Parade

The only thing standing between the American people and another apocalyptic financial collapse among by the biggest banks on Wall Street is the Federal Reserve’s stress tests and capital requirements. After Wall Street laid waste to the U.S. housing market and economy from 2008 through 2010, while propping itself back up with a feeding tube from the taxpayers’ pocketbook, the Obama administration passed the Dodd-Frank financial reform legislation in 2010.  It wasn’t so much legislation as it was an illusory 2300 pages of rules that might someday get implemented in a meaningful way if President Obama appointed tough cops to his financial regulatory bodies – which he decidedly did not do.

One of the promises in Dodd-Frank was that the Federal Reserve would annually assess whether the biggest and most dangerous banks have adequate capital to withstand a severe recession and whether the bank has the proper risk-management programs in place to prevent it from imploding and becoming a ward of the taxpayer.

Yesterday, the nonpartisan congressional watchdog, the Government Accountability Office (GAO), became the third Federal entity in the last two years to indicate that the Fed is muffing the job of stress testing the big Wall Street banks.

The GAO report notes:

“…the Federal Reserve’s organizational structure for the stress tests does not include a formal process through which model development or risk management at the aggregate—or system-of-models—level is implemented…By largely focusing the modeling principles on the component models and not applying those principles to the system of models, the Federal Reserve has limited its ability to manage the extent to which model risk is introduced into the supervisory stress test models.”

Another failing according to the GAO report is this:

“The Federal Reserve also has not conducted analyses to determine if its single severe supervisory scenario is sufficiently robust and reliable to promote the resilience of the banking system against a range of potential crises. Such analyses—including performing sensitivity analysis involving multiple scenarios—could help the Federal Reserve understand the range of outcomes that might result from different scenarios and explore trade-offs associated with reliance on a single severe supervisory scenario.”

Last year, the Federal Reserve was criticized in a report by its Office of Inspector General over the models in its stress tests. But far more alarming was a report issued just this past March by the Office of Financial Research (OFR), which was also created under the Dodd-Frank legislation.

The OFR report brought the illusory nature of the stress tests into sharp focus. A careful reading of the report strongly suggests that the stress tests are being used to simply comfort Congress and the public with the notion that Wall Street banks are not going to rapidly morph again into an exploding fireworks factory, when, in fact, there is no basis for that confidence

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