Dungeons & Dragons & Balance Sheets Every year, the nation's biggest banks are subjected to stress tests, hypothetical disaster scenarios designed to test their balance sheets. But the stress tests could soon be getting less stressful.
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Dungeons & Dragons & Balance Sheets

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Dungeons & Dragons & Balance Sheets

Dungeons & Dragons & Balance Sheets

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STACEY VANEK SMITH, HOST:

OK, here's the scenario. You find yourself in a dark room. You look around. You see some computers and a stock ticker. And the markets are down. The markets are way down. Stock prices are falling. You see a newspaper on the table. You look at the headlines - "Unemployment Hits 8 Percent," "Millions Default On Auto Loans." A question rises in your mind - can I weather this storm? Do I have enough cash to survive? No, this is not the world's most boring game of Dungeons & Dragons. It is in fact much scarier than that. You are a bank, and this is a stress test.

CARDIFF GARCIA, HOST:

Oh, that's...

VANEK SMITH: (Laughter).

GARCIA: That really got me, Stacey. Yeah, that's...

VANEK SMITH: Coming down? Coming down for a second?

GARCIA: Yeah, that was terrifying.

VANEK SMITH: (Laughter).

GARCIA: This week, 35 of the biggest banks in the country got the results of their annual federal stress tests. These tests are a part of the regulations that were put in place by Dodd Frank. That's the big bill that was passed after the financial crisis. And in a stress test, regulators invent hypothetical economic meltdown scenarios like the one Stacey just described. They run the banks' balance sheets and systems through a series of these tests to see, are the banks prepared? Do they have the systems in place to deal with the disaster in question?

VANEK SMITH: You know, it almost sounds like a video game or something, you know, or like a "Choose Your Own Adventure." It's like, you have reached the bridge. Like, there's a troll. Do you fight the troll? Do you run away?

MICHAEL BARR: (Laughter) I wish it were as entertaining as that.

GARCIA: What is he talking about? It's way more entertaining than that. If you work at THE INDICATOR, these hypothetical economic meltdowns are way more exciting, way more entertaining than trolls - again, only hypothetically.

VANEK SMITH: They're also scarier than trolls.

GARCIA: Yeah. I don't want the actual world to go through that again, just to be clear.

VANEK SMITH: No.

GARCIA: This is THE INDICATOR. I'm Cardiff Garcia.

VANEK SMITH: And I'm Stacey Vanek Smith. Today on the show, the banking industry's dreaded stress tests - what they are, who passed and who failed this year, and why a lot of banks are not going to have to take them anymore.

(SOUNDBITE OF MUSIC)

GARCIA: Today's indicator is one. That's the number of banks that failed this year's stress test. The flunkee in question was Deutsche Bank. Well done, guys. Although three other financial institutions, including Goldman Sachs and Morgan Stanley, only kind of passed.

VANEK SMITH: It was a soft pass.

GARCIA: Yeah. But if these banks are looking for someone to blame, this guy should probably be on the list.

BARR: Hello, my name is Michael Barr. I'm dean of the Gerald R. Ford School of Public Policy at the University of Michigan.

VANEK SMITH: And you were one of the architects of Dodd Frank.

BARR: I was.

VANEK SMITH: Tell me about - like, how did the idea of stress tests first come up?

BARR: Well, this started during the darkest days of the financial crisis in the early part of 2009.

VANEK SMITH: Early 2009 was not a test. The stock market's value had basically fallen in half. Unemployment was at 10 percent. Millions of people were defaulting on their home loans. Banks were in terrible financial shape, and nobody knew how much worse things might get. And the government wanted to be prepared. So Treasury Secretary Tim Geithner started going around to banks saying, OK, listen; if this happened, would you be solvent? Would you need a bailout? What about if this happened?

GARCIA: And specifically, one of the main things these stress testers were looking for was how strong the capital positions were of these banks in these stress test scenarios. And a strong capital position just means that a bank has more assets than liabilities with room to spare. So in other words, that the bank hasn't borrowed so much money that it would go insolvent if it then loses money in one of these stress test scenarios.

BARR: There were still a significant concern in the market that many of the largest financial institutions were too weak to survive the continued battering in the financial crisis. So Tim and his team put together these series of stress tests. So what we did when we were shaping up the Dodd Frank Act is take that basic idea that had been done as an emergency measure in the crisis and say, wouldn't it be smart to regularly stress test the largest financial institutions in good times and in bad so that we have a handle on what would happen to them if financial conditions worsened?

VANEK SMITH: Michael says when he and his colleagues were drafting Dodd Frank, stress tests were one of the first things they put in place.

GARCIA: Yeah. And it was a way to ensure that people could have confidence in U.S. financial institutions going into the future.

VANEK SMITH: I'm curious. Why was - why a stress test, and why not just put, like, a bunch of rules in place? Like, you have to have at least X amount of cash on hand. I mean, why a test?

BARR: Well, we have both kinds of things in the Dodd Frank Act, rules but also stress testing. The idea is that you really need both. You need kind of belts and suspenders. But the stress tests are really important because they're dynamic. They let you test what happens when things change, when things go wrong.

GARCIA: And not only is the stress test a test, it's also a pop quiz. The banks didn't know what kind of disaster scenarios the regulators were going to choose. Would it be mass credit card defaults or an economic meltdown in Europe, a tech sector downturn? Michael says the element of surprise is really, really important here.

BARR: The underlying models are not fully revealed to the financial institutions because if they are, they can be gamed. Financial institutions can put things in different buckets. They can move things around their firm in ways that would hide the real risk the firm is facing.

VANEK SMITH: In other words, banks would be able to find loopholes. Early on, banks failed these stress tests all the time. But more recently, the economy has improved. Banks have been doing really well. And they've just learned to keep stronger balance sheets. Also, many have gotten out of some of their riskier businesses.

GARCIA: So even though the tests have actually gotten harder, the pass rate has gotten better. Last year, for example, everybody passed. This year's test was arguably the toughest ever. And it had a few curveballs - 10 percent unemployment, the stock market drops by two-thirds, home prices drop by almost a third.

VANEK SMITH: Deutsche Bank failed the test entirely. The Federal Reserve said the bank showed, quote, "widespread and critical deficiencies across capital planning practices." In other words, their balance sheet was not strong enough to weather the disaster scenario.

GARCIA: Critics of these stress tests have said that the public humiliation aspect is kind of destructive, that it damages the bank's business and drives investors away. And also, that preparing for these tests can cost banks hundreds of millions of dollars, which is money that the bank can't use to either grow or to lend out.

VANEK SMITH: Right. And when a bank fails like happened this year, there's just a lot of pain involved. Michael says Deutsche Bank can expect regulators to just descend upon it. And they will have to immediately start beefing up their balance sheets.

GARCIA: Yeah. Unlike the critics, though, advocates of these stress tests think it's quite a good thing that the banks will have to strengthen their balance.

VANEK SMITH: Right.

GARCIA: Yeah. It's like the whole point of the test, right? Goldman Sachs and Morgan Stanley technically should have failed, but the Fed is giving them a pass because the reason these banks would have failed were one-offs, had to do with the temporary losses that resulted from the big tax bill passed last year. So, yeah, again, a soft pass.

VANEK SMITH: Michael Barr says these failures or near-failures don't worry him. He says a good stress test probably should see a few banks struggle. What worries him are all of the banks that won't be taking the stress tests next year. That is because of the recent rollback of parts of the Dodd Frank legislation that made it so a lot of mid-sized banks like Zions and Santander will not have to take stress tests anymore. So instead of 35 banks taking the stress tests, only about a dozen will.

GARCIA: Yeah. Michael says this is a mistake because if you put a few mid-sized banks together, you get a really big bank. And in fact, he says, that's what happened in the financial crisis. Lehman Brothers was not a giant bank, but it was deeply connected with a bunch of other banks. And when it failed, it caused enormous damage to the economy.

BARR: So we really have blinded ourselves to risk in the financial system. And I think it's a significant mistake. I think we have intentionally forgotten the really significant causes and consequences of the last financial crisis.

VANEK SMITH: In fact, the Federal Reserve is reportedly going to largely do away with the whole pass-fail scenario. And that would mean that if a bank fails, it would just privately be told what its cash requirements would need to be for the next year - no public embarrassment.

GARCIA: Yeah. And maybe the stress tests in that case will be more like mildly distracting tests.

VANEK SMITH: Exactly - less blood troll, more tree troll.

(SOUNDBITE OF MUSIC)

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