Turbo Tim's Stress Test: Always A Ruse for TBTF

It wasn’t all that long ago that bank stress tests were designed specifically to ensure 100% passing rates. The purpose of the exercise has nothing to do with bank safety or even oversight, it is a mode of pure psychology (bordering on propaganda). The first introduction back in 2009 was effectively that – to calm investor fears by stamping the Fed’s imprimatur on all banks. It certainly helped that they didn’t run that stress test in 2008 before TARP created enough capital room to simulate a little more realistic “worst” case scenario (no one was ever made to explain why the “worst case” in the 2009 scenarios were far less “worse” than what had actually happened to many participants in 2008).

Extend and pretend had by then been incorporated as an actual policy. The intent was to put out every fire then raging by convincing asset markets the worst was over; then wait for the cavalry in the form of a cyclical recovery. It never came.

This week’s release of the latest stress test results still finds several banks short of being called sufficient, most prominent of that bunch being Citigroup. Among the potential deficiencies, the Fed cited an inability to estimate potential losses “for material parts of the firm’s global operations in a sharp economic downturn.”

Given that the definition of “sharp economic downturn” is itself a matter of contention should render even more pause. But that aside, Citigroup’s major deficiency is that it is far more of a subprime lender than its major peers. The bank tends to credit cards and auto loans rather than mortgages, a la Wells Fargo, or the “flow trading” of BofAML. After experiencing a drastic crisis (which was really a bank panic consisting of nothing but banks panicking) you might expect by now a more nimble assessment that captures actual finance as opposed to skimming a quarterly statement.

The reason any of this is news apart from the interest of stock gamblers is that Too Big To Fail is an enshrined fact of the financial landscape within a system in which financial dominates. It isn’t just the bigs of the industry, they are behemoths on any scale. The further distance from the last affair only courts increasing apathy to the subject (which, I suspect, is the main point).

Over at FRBNY’s blog (which, despite the branch’s physical location on Liberty Street, makes me wonder if they actually still believe central banks are consistent with liberty; libertystreeteconomics.newyorkfed.org) the topic has been rehashed in such a timely fashion. The essential narrative up to this point is summarized as,

The takeaway from these three papers is that bank size has benefits and costs: The upside is the potential for economies of scale and lower operating costs; the downside is the TBTF problem and the attendant funding advantages and moral hazard.

I don’t think it is possible to be more underwhelmed by “research” that takes to stating the obvious. Betraying what might be fairly called an unfamiliarity with more realistic “economics”, how else might banks become too big to fail if not through economies of scale that lower operating costs? I suppose there is something to stating an out and out tautology, but that isn’t largely helpful in the far more important aspect of mitigating the downside to which we are all unfortunately familiar.

It is quite striking to see that in the days just before the worst of the panic was unleashed, after Lehman, AIG and Wachovia, Richard Fisher of the FOMC actually brought up the topic of too big to fail.

MR. FISHER. Mr. Chairman, this may be a conversation for another day, but it seems to me that we’re ending up with more and more concentration—Bank of America, Citicorp, Morgan—and I’m curious as to what we plan longer term so as not to displace the ability of other institutions to play their role in the financial markets and grow their businesses—the super-regionals that are healthy and so on.

There was no real response, leaving President Fisher’s thought as simply a rhetorical exercise. That is really a shame since that would have been the ideal time to have a discussion on too big to fail. At that point, the banks were at the mercy of the Federal Reserve and the government, through faults on both sides, and any resistance to a major plan of overhaul could have been necessarily included in TARP. And it was not like it had never been done before; the Swiss National Bank was carrying out exactly that plan at exactly that time, essentially gutting their “big 3” from the inside out.

Back to Fisher:

MR. FISHER. But I guess just philosophically what concerns me longer term is that, in response to these actions, there are no other people to take these steps, but we’re creating larger and larger concentrations and bigger and bigger situations where we have too big to fail. I’d just like at some point to have a conversation on that matter. I’m not objecting to the move taken, obviously, but it is going to present a bigger problem as we go down the path because we’re getting increasing concentration in fewer and fewer institutions.

The very idea of these forced mergers was an economy of scale, not necessarily in terms of funding or operational costs but bank capital. If that might properly be called an emergency measure to do it in September 2008 (after taking the plunge in March 2008 with Bear), why no later move to unwind? If the emergency had passed, surely the need for that capital economy had as well.

Like Fisher’s concern, that is a rhetorical exercise because there is only one direction this can go. You cannot unmerge that which has been entangled, a fact that was prominently displayed in the later discussion (in that FOMC meeting) of Wachovia’s “integration.” And that ultimately proves Fisher’s assertion, that nobody gave it any thought then and has not in the days since (except to cite tautologies, apparently).

To drive that home, Chairman Bernanke’s immediate response to Fisher was hollow empathizing.

CHAIRMAN BERNANKE. But I agree with that. We have been very constrained throughout this entire crisis, as you know, by the existing facilities for dealing with failing institutions and mergers being one of the only tools we have. Going forward, I think there is some hope in the near term under the new TARP, which would allow resolutions using capital injections basically without necessarily doing a merger. Then subsequently, I think it’s very important, as we look toward restructuring our financial regulatory system, to develop good resolution mechanisms and to think about the issues of concentration and too big to fail.

I hope no one is holding their breath in anticipation of the development of “good resolution mechanisms.”

One last reminder, it was only briefly addressed in 2008, but the responsibility for all this is clear though nobody wanted to admit as much outside of this very fleeting soliloquy from Thomas Hoenig.

MR. HOENIG. The problem has been very lax lending and, obviously now, weaknesses in some of the oversight. Also a history of our reacting from a monetary policy point of view to ease quickly to try to take care of the problem and, therefore, to create a sense in the market of our support has raised some real moral hazard issues that we now need to begin to remedy as we look forward in dealing with future receiverships. We are in a world of too big to fail, and as things have become more concentrated in this episode, it will become even more so.

Can anyone make a reasonable case that anything has changed? They are all still preoccupied, some six and a half years after initial eruption, with shoveling fleas.


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