Last week the Federal Reserve released the results of its annual stress test of large banks, a comprehensive analysis of what would happen to the financial health of those institutions if the economy underwent a period of severe adversity.
Fifteen of 19 banks subjected to this year's test met the minimum standards set by the Fed. So should bank customers be more focused on the 15 banks that passed, or the four that failed?
Here are five points to help put these results in perspective:
- Overall, the results show progress. Even under a hypothetical scenario of severe setbacks, the financial condition of the 19 banks in aggregate is better than their actual financial condition in the fourth quarter of 2008. In short, the ability of banks to weather adversity has improved.
- No test is perfect. To simulate extremely bad economic conditions, the Fed assumed the immediate onset of a severe recession, resulting in a 13 percent unemployment rate, a 50 percent drop in the stock market, and a 20 percent drop in home prices. Does this truly represent a worst-case scenario? Certainly not. There have been more severe conditions than that in the past, and with today's complex investments and counterparty relationships, it is difficult to perfectly estimate the reaction of financial assets to economic events. Still, while no test can account for every possible scenario, the Fed's test does seem to hold the banks to pretty rigorous standards.
- Ordinary depositors should not be overly concerned with the results. Customers with savings accounts and other deposits within FDIC insurance limits should not panic if their banks failed the stress test. The insurance gives those customers the risk protection they need, so they should only be concerned if the banks try to improve their financial performance by making moves that affect customers, such as discontinuing high interest savings accounts or free checking, or cutting back on service.
- The public release of the results is significant. Notably, the Fed had to move up its release of the results by a couple of days because banks that did well started to leak the results. This shows how much public knowledge of those results matters to the banks, which should put pressure on the under-performing banks to improve.
- The existence of the tests is a good sign. Acknowledging the possibility of a downside scenario is important; it's when bankers and regulators are confident that the worst will never happen that things tend to go wrong.
With regulators scrutinizing bank financials, customers can afford to focus less on those financials and more on what products and services they get from the bank -- competitive interest rates on savings accounts, responsive customer service, free checking and so on. As long as FDIC insurance is in place and the regulatory watchdogs are watching the financials, customers can base their decisions on how the bank performs for them -- not for the Fed.