Stress tests for midsize banks are more trouble than they’re worth

While stress testing can provide valuable insight into the strength and resilience of our financial system, regulators are increasingly acknowledging shortcomings in the post-crisis regime — and the critical need to review and reform these programs to make them more realistic, more transparent and more tailored.

In March 2017, bank regulators issued a report detailing ways to reduce unnecessary regulatory burden while maintaining safety and soundness, something the Economic Growth and Regulatory Paperwork Reduction Act (EGRPRA) requires them to do at least every 10 years. The banking agencies’ recent proposal to simplify regulatory capital standards is an important step toward fulfilling promises made in March — a welcome recognition that some bank regulation provides more burden than benefit.

A range of defects in the stress-testing structure hurt America’s midsize, regional and large banks, and are in need of repair. Unfortunately, some rules that even regulators acknowledge are improperly calibrated cannot be remedied without congressional action. As an initial matter, the Dodd-Frank Act’s arbitrary asset thresholds of $10 billion, $50 billion and $250 billion — with an array of corresponding stress test mandates — crudely divide the industry in a manner that is unrelated to actual risk, and needlessly tie the hands of agencies seeking to strike an appropriate regulatory balance.

T.J. Kirkpatrick/Bloomberg

For example, consider the effects of these distortions on midsize banks. Dodd-Frank mandates stress tests on all banks with $10 billion or more in consolidated assets. That midsize bank requirement, meant for institutions with a limited reach, was still clearly patterned after banks whose failure might pose a risk to the stability of the financial system.

Midsize banks are extremely unlikely to present systemic risk to a U.S. banking system that safeguards over $13 trillion in insured deposits and extends more than $9 trillion in loans. By their nature, midsize banks have modest financial and geographic footprints. Yet their stress testing regime relies on national macroeconomic scenarios that are not relevant to them.

This is a misallocation of resources that the regulators recognize, but they have little discretion because the statute holds midsize banks to much the same stress test scenarios and disclosure requirements as it does the nation’s most complex institutions.

In the EGRPRA report, both the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. highlighted midsize bank stress testing as an example of unnecessary regulatory burden, and expressed support for legislation to eliminate the requirement. The Federal Reserve Board has expressed similar sentiments. In letters to both the Senate Banking and House Financial Services committees, then-Fed Gov. Daniel Tarullo stated that he was “sympathetic to the argument offered by some smaller regional banks with between $10 and $50 billion in assets that they should be excluded from all stress testing requirements.”

Subsequently, we learned that former Governor Tarullo’s sympathies are shared more broadly at the Fed. In written testimony to the Senate Banking Committee, Gov. Jerome Powell stated without equivocation that the central bank supports increasing the $10 billion midsize bank stress testing threshold.

Dodd-Frank also requires public disclosure of stress testing results. This disclosure serves only to confuse the public, since the scenarios themselves aren’t relevant to the bank or their communities. To their credit, the banking agencies understand this perception problem and have discouraged the public from relying on these midsize bank stress test results. In so doing, they acknowledge that midsize banks have “distinctly different geographic markets, exposures, activities, methods, and assumptions across companies.”

Not only are these stress tests not useful, they pull resources away from both supervisors and bank managers that could instead go toward serving customers. A typical midsize bank produces thousands of pages of documents and spends roughly 10,000 man-hours hours to comply with stress testing requirements. For banks that are approaching the $10 billion assets threshold, the contemplation of such impending costs of compliance can be staggering. Simply put, the burden of bank compliance far outweighs the supervisory benefits realized by the midsize bank stress test.

The time is right for policymakers to engage in a comprehensive review of the timing, transparency and effectiveness of stress testing. Congress can help by eliminating the midsize bank stress testing requirement altogether. Post-crisis hastiness to regulate now and ask questions later on this issue has produced years of effort and data that are of little use to banks or regulators.

The failure to tailor stress-testing requirements properly when Dodd-Frank was first enacted is also a powerful reminder that crude regulatory divisions based solely on the amount of assets a bank holds is the wrong approach. Our regulatory system must move toward a regime that better reflects the diverse business models and risk profiles of our nation’s banks.