Federal Reserve's Bank Stress Tests Dinged in GAO Review

The following article, originally published at 2:42 p.m. on Nov. 15, 2016, has been updated with comments from Fed officials and lawmakers. 

The more you know about what a test will cover, the easier it is to prepare.

That's a premise that holds true from elementary school spelling quizzes to university finals and regulatory reviews of larger corporations, such as the annual stress tests given to the biggest U.S. banks.

Banks are required to pass the reviews in order to make billions of dollars in share repurchases and dividend payments, but critics have pointed out that the opaque nature of some of the criteria, particularly the so-called qualitative assessments, makes it difficult for executives to determine what the Federal Reserve expects until it's too late.

Correcting that is one of the key changes recommended in a review of the stress tests published Tuesday by the Government Accountability Office, the investigative arm of Congress.

"Transparency is a key feature of accountability and such incomplete disclosure may limit" understanding of the assessments as well as the market's confidence in the reviews," the accountability office said. Limited transparency also makes it difficult to ensure the Fed is treating disparate companies fairly, the report said.

The central bank "hasn't disclosed information needed to fully understand its assessment approach or the reasons for decisions to object to a company's capital plan" on qualitative grounds, the office said in the report, requested by House Financial Services Committee Chairman Jeb Hensarling, a Texas Republican.

"Other than the Fed, nobody's really happy with the stress tests," Richard Bove, an analyst with Rafferty Capital Markets, said in a telephone interview after the report was published. Both banks and their investors, who rely on the information, would prefer greater clarity, he said.

The examinations were established as Congress sought to prevent a recurrence of the 2008 financial crisis, when the imploding $15 trillion U.S. mortgage market led to the collapse of investment bank Lehman Brothers and froze global credit markets.

The Federal Reserve largely concurred with the office's assessment and had made progress addressing many of the report's concerns even before it was published.

The central bank acknowledged questions about the qualitative review, in particular, and has attempted to make the process more transparent every year since it began in 2011, Michael S. Gibson, the director of the Fed's banking and supervision unit, said in a letter included with the report.

Regulators will continue to provide more insight into the areas the GAO identified, through steps such as "disclosing additional information on the qualitative assessment process, detailing its reasons for decisions to object to specific firms' capital plans" and describing what the central bank considers to be best practices, Gibson wrote.

More clarity on the qualitative standards would be welcome news for banks, many of which have run afoul of them over the past several years. The Fed cited deficiencies in capital-planning processes at Morgan Stanley (MS) this year, at Bank of America (BAC) in 2015 and at JPMorgan Chase (JPM) and Goldman Sachs (GS)  in 2013.

While all received conditional approval to go ahead with capital payouts, they were required to resubmit their plans.

At Citigroup (C) ,  Fed regulators blocked payout proposals in 2014 because of weaknesses in areas including the bank's ability to project revenue and loss for significant operations during periods of economic stress and problems measuring how its full range of businesses would respond to challenging market conditions.

Representatives of Morgan Stanley, Bank of America, JPMorgan Chase, Goldman Sachs and Citigroup all declined to comment on Tuesday.

"The GAO report confirms the secrecy surrounding the stress tests makes it almost impossible to measure the effectiveness of the Fed's regulatory oversight or the integrity" of the findings, Rep. Hensarling said in a statement. "When it comes to the Fed's stress tests, not only are they not transparent, they are often duplicative and impose unnecessary costs and burdens on financial institutions that are ultimately passed on to consumers."

Hensarling, who said the Fed has become part of a "shadow regulatory system" cited the report as evidence that his own Financial CHOICE Act -- a Republican alternative to the Dodd-Frank Act mandating the stress tests that was passed by a Democratic Congress in 2010 -- would be an improvement. 

That bill likely has greater odds of approval after the GOP's sweep of the executive and legislative branches of the federal government a week ago. Hensarling also urged President-elect Donald Trump to designate a vice chairman for supervision at the Federal Reserve who would oversee its regulatory efforts.

The duties of the post, currently vacant, have been handled by Fed Governor Daniel Tarullo, who argued against excessive disclosures related to supervisory stress tests in a September speech because they would "permit firms to game the system" and take outsize risks in areas "not well-captured" by the review.

Some banks have suggested the Fed disclose a version of the supervisory letters it sends to executives on their capital-planning processes because the insight would benefit analysts and investors, Tarullo said at the time. The Fed will consider that as it works to improve clarity around the qualitative reviews, he said.

While there are valid reasons for conducting stress tests, banks need the additional disclosures about the Fed's methodology that the report suggests, said a person familiar with the industry.

Since the review is "an enormously costly process," Bove said, "it's only fair that it be transparent, both in terms of how decisions are made to come up with the parameters of the stress tests and how evaluations are going to be done."

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