Thesis: The Fed has to be strict with the banks.
The Fed conducted annual stress tests on the 31 largest U.S. financial institutions this week. The purpose of the test is measure two things: “Whether banks can weather a hypothetical recession, and whether they have good processes for identifying and preparing for risks.” The first measure is a quantitative assessment of how well capitalized the bank is; that is, how much capital they will have available to smoothly continue their lending operations in significant economic downturns. This is a relatively straightforward measurement that yields a simple yes or no answer.
The second aspect of the test is a lot more interesting; it is a qualitative assessment of a bank’s internal processes of identifying and managing risk. The reason this is the more interesting component is because it defines the conduct and culture that the Fed deems appropriate on Wall Street.
In a Bloomberg View editorial, David Shipley writes:
“Better regulation is essential. Particular attention has to be paid to the dangers of excessive systemwide leverage, and banks and other financial instructions need to be better capitalized. In this and other respects, aligning tax and regulatory incentives with the public interest is no simple task. But the guiding principle in this work shouldn’t be the idea that finance is a fraud on the public and Wall Street a nest of vipers. The purpose of regulatory reform shouldn’t be punishment.
Rather, the aim should be to promote prosperity. A vibrant, innovative financial sector is a vital economic resource. Talented and hard-working people are well deployed in such an industry, and deserve to be well-rewarded. Anger has had its day, and it’s time to move on.”
The first part of Shipley’s argument concerns the first aspect of the Fed’s stress test – the quantitative assessment of capital levels that is relatively easy to monitor. However, the second part of Shipley’s argument concerns the Fed’s qualitative assessment. In Shipley’s view, the Fed should promote prosperity, and encourage a culture on Wall Street that creates new financial instruments, and rewards themselves for it. But isn’t that exactly what led to the sub-prime mortgage crisis? Bankers created new financial instruments called mortgage-backed securities, and didn’t fully understand how they worked. That was a huge factor in the financial meltdown. While I am not suggesting the Fed to discourage innovation, as the sole regulatory body the Fed has to use punishment to keep the banks in check.
It is almost like Shipley is suggesting the Fed to be the “fun parent,” but doesn’t it seem like those are the kids that always end up in trouble?