Bank Stress Tests Getting an Overhaul

Summary

WSJ Your Money Briefing: “Bank Stress Tests Getting an Overhaul”

Air date: June 27, 2018
Host: JR Whalen
Guest: Ryan Tracy, WSJ Financial Regulation Reporter

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Episode Overview

This episode of “Your Money Briefing” explores significant upcoming changes to the Federal Reserve’s bank stress tests. These regulatory tests, introduced after the Great Recession, have played a key role in assessing the financial health and risk-management capabilities of major U.S. banks. With the financial system more stable, the Fed is considering overhauling how results are reported and what they mean for banks, investors, and the broader public.

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Key Discussion Points & Insights

1. Purpose & Background of Stress Tests

Timestamp: 02:39

• Origin: Stress tests were created after the financial crisis to determine whether banks could withstand a major recession and continue lending without government bailouts.
• Frequency/Importance: The annual results have become a high-stakes event for banks, investors, and regulators.
• What’s Tested: Banks are evaluated using hypothetical severe economic scenarios to see if their capital levels are sufficient.

Quote:

“The stress tests were invented after the recession as a way of examining whether banks could go through a significant downturn in the economy and continue lending, continue doing what banks do without requiring some sort of taxpayer bailout.”
—Ryan Tracy (02:39)

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2. Recent Bank Performance

Timestamp: 03:24

• Participation: 30–40 of the largest U.S. banks take the tests yearly.
• Results: Most banks have passed in recent years, with failures becoming rare.
• Reasons for Success:
  • Post-crisis, banks have substantially increased capital reserves.
  • Improved risk management practices.

Quote:

“After the recession, banks have really built up their capital levels. So when they go through this hypothetical doomsday scenario, they do better than they maybe would have in 2007.”
—Ryan Tracy (03:29)

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3. Upcoming Changes to the Stress Test Regime

Timestamp: 04:16

• Shifting Focus: The Fed is moving from a pass/fail system (where failed banks faced public scrutiny and leadership shakeups) to an approach that emphasizes numerical capital results.
• Reduced 'Stick': Direct public shaming or high-profile failures—like Citigroup’s in 2014—are less likely, reflecting greater bank stability.

Quote:

“...Rather than passing a bank each year or failing a bank each year and having that headline that grabs the attention of the CEO, instead, they're going to release just the numerical results of the test.”
—Ryan Tracy (04:16)

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4. Public versus Private Results

Timestamp: 05:30

• Quantitative Results:
  • Will remain public.
  • Show how much capital a bank maintains under stress.
• Qualitative Results:
  • Will become private.
  • Assess risk management practices, board oversight, data capabilities.
  • Failures for qualitative reasons (e.g., weak management, slow risk assessment) will no longer trigger public consequences.

Quote:

“The qualitative part of the test is the one that's going to go private...we don't need to fail a bank based purely on these qualitative reasons. We think the banks are doing a better job.”
—Ryan Tracy (06:07)

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5. Implications for Banks and Investors

Timestamp: 06:32

• If a Bank Falls Short Quantitatively:
  • Rather than failing outright, the Fed would require the bank to raise more capital.
  • Results could affect dividends and stock buybacks but would not carry the same reputational weight as previous failures.
• Ongoing Importance:
  • Stress tests and capital levels still matter for regulatory oversight, shareholder payouts, and public confidence.

Quote:

“The stress tests are still going to matter. But, but this kind of pass fail conversation is going to be replaced with a number.”
—Ryan Tracy (07:18)

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Memorable Moments & Notable Quotes

• On the weight of past failures:

  “When Citigroup failed in 2014, it was a huge deal for that bank. The CEO's job was on the line. And it was a message from the Fed that it was unhappy with the way Citigroup was being run...”
  —Ryan Tracy (04:32)

• On why qualitative results are going private:

  “A lot of banks weren't able to [quickly assess their risk to firms like Lehman Brothers] in 2008. So the qualitative part of the test ... we don't need to fail a bank based purely on these qualitative reasons. We think the banks are doing a better job.”
  —Ryan Tracy (06:00)

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Important Timestamps

• 02:39: Introduction to stress tests — what they measure and why they matter
• 03:24: Track record of bank performance and reasons behind improving results
• 04:16: Explanation of changes: from pass/fail to numerical results
• 05:30: Distinction between quantitative (to remain public) and qualitative (to become private) results
• 06:32: What happens if banks fall short; implications for dividends and buybacks
• 07:31: Wrap-up and key takeaways

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Summary

This episode clarifies that while the Fed’s stress tests will keep playing a crucial role in ensuring bank stability, the regulatory regime is evolving. The pass/fail drama that once grabbed headlines is set to be replaced by a system focused on capital figures, with internal management assessments taken behind closed doors. These changes reflect both improved bank health since the financial crisis and a shift in regulatory philosophy.

Listeners are left with the reassurance that banks are stronger and that the stress test process, though less sensational and publicly punitive, will continue to safeguard the financial system.

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End of Summary

Transcript

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[JR Whalen]

from the Wall street journal.

I'm J.R. whalen in New York. Stress tests administered by the Federal Reserve can tell a lot about a bank's liquidity in times of crisis. We'll explain in a moment why those tests are likely to undergo significant changes. First, these money headlines. Americans view the economy with some of the highest levels of optimism in years, but their rosy outlook has dimmed as they look to the future. The director of economic indicators at the conference board says the pullback and optimism suggests that consumers do not foresee the economy gaining much momentum in the months ahead. Confidence soared starting in late 2016, but stocks have wobbled this year after rising sharply in 2017. Plus, signs of softening economic growth have appeared in Europe and Asia, and interest rates and gasoline prices have risen in the U.S. those are developments that could hinder consumer spending. And new research suggests that women frequently underestimate the time, money and effort it takes to raise children and have a career at the same time, leading many to invest in their skills and then reluctantly leave the workforce when the true costs of being a working mother become apparent. Since around 1990, the study found that about 2% of 18 year old women who participated in the University of Michigan Survey of Young Americans Attitudes and Values said they expect to be stay at home mothers by the age of 30. Yet yet 15% to 18% of American women become homemakers by age 30, suggesting that many expected to combine work and motherhood and then reversed course. This is your Money briefing from the Wall Street Journal. Welcome back, everybody.

Since the recession, one of the more closely watched days on the calendar has been the day when results of bank stress tests are released by the Federal Reserve Wall Street Journal Financial regulation reporter Ryan Tracy joins us to explain why those stress tests could relic of the past. So Ryan, the latest batch of test results are released on June 28th. Could you just briefly explain what the stress tests are and what they measure?

[Ryan Tracy]

The stress tests were invented after the recession as a way of examining whether banks could go through a significant downturn in the economy and continue lending, continue doing what banks do without requiring some sort of taxpayer bailout. The tests have become more and more important as they've become more and more central to the way that the Federal Reserve examined banks. So each year, the Fed will reveal these results, looking at how banks perform under a hypothetical scenario. And based on those results, the banks pass or fail the tests. And failures can have some negative consequences for the banks. And so for bank investors and for just regular old citizens who care about this stuff, this can be a very important day.

[JR Whalen]

And for the banks, for the most part, they have fared pretty well in these tests, with a couple of exceptions.

[Ryan Tracy]

Yeah, usually there's about 30, between 30 and 40 banks taking them every year. These are mostly the largest banks in the United States, and generally the vast majority of them pass, with a couple of exceptions. And that reflects two things. One, that after the recession, banks have really built up their capital levels. So when they go through this hypothetical doomsday scenario, they do better than they maybe would have in 2007. Also, it reflects the fact that they've done a better job, in the Fed's view, of improving the way that they manage their risk, of improving the way that they prepare for the worst.

[JR Whalen]

And under these new processes that the Fed is proposing, it would put a focus on the bank's capital levels and really do its measurements from there.

[Ryan Tracy]

Right. So what we're looking forward to as the tests move forward is really a change in the form of the grades that the Fed issues every year. The Fed has used these tests as a stick. When citigroup failed in 2014, it was a huge deal for that bank. The CEO's job was on the line. And it was a message from the Fed that it was unhappy with the way Citigroup was being run and wanted to see and the pace at which Citigroup was making improvements that the Fed thought the bank needed to make. The Fed's now at a place where we're not seeing failures like that as often. And the Fed is kind of feeling like it doesn't need this stick as much as it used to. So the Fed's rolling out some changes that rather than passing a bank each year or failing a bank each year and having that headline that grabs the attention of the CEO, instead, they're going to release just the numerical results of the test. Those results indicate where a bank's capital was. And that's still going to be very important, don't get me wrong. But it's going to be a different world than A bank failing the test.

[JR Whalen]

And so just to be clear, as these tests go forward, the results, some of which will be private and some will be public, is that right?

[Ryan Tracy]

Yeah. So just getting into the weeds a little bit so people can understand why we think this, why we see this change coming. There are two main aspects of the stress test. There are the quantitative results and the qualitative, more subjective ones. The quantitative results will show you a bank's capital level was at a certain percentage after going through this tough hypothetical recession. And the Fed wants to see that the bank's capital levels are, are at a certain minimum to ensure that they can stay open. The qualitative results are more subjective. They deal with things like, you know, did the bank's board of directors do a good job questioning management to make sure that the managers of the bank are taking into account the risk that they face? They deal with things like internal data. Is the bank able to quickly calculate its exposure to, say, a firm like Lehman Brothers in a couple minutes? The Fed thinks the bank should be able to do that because if Lehman was in trouble, the bank needs to know how much money it was going to lose. And a lot of banks weren't able to do that in 2008. So the qualitative part of the test is the one that's going to go private. That's the one that the Fed has decided, you know what, we don't need to fail a bank based purely on these qualitative reasons. We think the banks are doing a better job. And so we're going to take that away from the test. The Fed hasn't formally proposed that, but they've made it very clear that's going to happen over the next couple years. And on the quantitative side, the Fed has proposed that it would no longer fail banks purely for going below a certain capital level. Instead, what they would do is tell the bank, you know what, you're going to need to raise more capital over the next year. And you know that's going to be important for banks. That's going to affect the dividends they pay to their shareholders. That's going to affect the buybacks that they are able to do in terms of returning profits to shareholders that way. So that's going to be really important. And the stress tests are still going to matter. But, but this kind of pass fail conversation is going to be replaced with a number.

[JR Whalen]

All right, that is Wall Street Journal reporter Ryan Tracy, joining us from our bureau in Washington. Ryan, thanks for being with us.

[Ryan Tracy]

Thanks for having me.

[JR Whalen]

And that's your money briefing. I'm JR Whalen in New York for the Wall Street Journal.

[Small Business Owner]

Access to affordable credit helps me pay my employees. But I don't really need it.

[Retail Industry Representative]

Inflation is killing me. But who cares? Big retailers are making record profits. That's why we support the Durbin Marshall credit card bill.

[Small Business Owner]

See, banks and credit unions help small businesses make payroll. This bill would cut the vital resources

[Retail Industry Representative]

they need while increasing megastore profits. They deserve it, don't they?

[Consumer Advocate]

Tell Congress, stop the Durbin Marshall money grab for corporate megastores paid for by the Electronic Payments Coalition.