NEW YORK (TheStreet) -- The Federal Reserve system's stress tests, to put it bluntly, are a bunch of baloney.
The old stationary methods of determining whether or not banks were financially sound was just not adequate to handle the severity of the financial crisis that preceded the Great Recession. So, something else had to take the place of the previous methodology and simulation tests were substituted. There has been nothing but chaos since.
Most of the largest banks in the U.S. passed the latest round of tests -- save Bank of America (BAC) and the U.S. branches of Germany's Deutsche Bank (DB) and Spain's Santander -- the results of which were released this week.
Three other major financial institutions passed only marginally. J.P. Morgan Chase (JPM) passed only provisionally. It could fail later this year because it still has deficiencies that need to be attended to. Goldman Sachs (GS), and Morgan Stanley (MS) must also "alter planned payouts to investors" to be fully certified as passing.
So, is the financial services industry safe from catastrophic failure? Maybe. But the stress tests aren't helping all that much.
First, the building of these simulation models are not cheep and they require a lot of additional staff to support them.
Deutsche Bank put out a statement on the subject, which revealed the stunningly high amount of resources the bank expends on compliance, of which the tests are a part, "Deutsche Bank has hired 1,300 employees dedicated to ensuring that its systems and controls are best in class and has hired over 500 employees across its various control functions in the U.S."
Second, quoting from Peter Eavis in the New York Times, "Some bankers criticize the test contending that they are unpredictable."
The tests are "unpredictable" because Federal Reserve officials don't want them to be predictable because banks can then "game" the system and make the tests useless. This, many people would argue, is what happened with the old "stationary" tests.
How they become "unpredictable" is that test-makers determine what stress conditions the banks will face. "Firms should plan for unforeseen risks," according to Eavis.
For example, this year, greater market volatility was assumed this year than in the past. This ended up producing greater losses for those institutions that are more active in the capital markets, like J.P. Morgan, Morgan Stanley, and Goldman Sachs. A bank like Wells Fargo (WFC) would not be impacted nearly as much.
Herein lies the rub. How a particular bank performs against the stress test in any one year depends upon the assumptions that are used in the simulations. Just looking at the above example, one could argue that the Fed could specifically "go after" certain banks or certain types of bank activities in any one given year by the assumptions that are used that year for the simulations.
So, what do the stress tests show? Not much because it depends upon the specific assumptions used in that year. And, because the assumptions change, it is hard to say that this year's results can be compared with last year's results.
Does that mean the financial system is safe because most of the banks passed the latest rounds of tests? Maybe -- depending on what you assume.