A recent New York Times article pointed out that the US Federal Reserve’s stress tests for banks have become more rigorous in recent years. What used to be a once-a-year, superficial test has evolved into a year-long process. When the program began, 150 employees were tasked with implementing tests and models – today that number stands at 600.
These stress tests are intended to measure banks’ resilience in the face of significant economic decline – as it did in the recent recession. In order to prevent banks from ‘gaming’ the system the Federal Reserve keeps its models a secret, meaning that financial institutions are not able to build certain portfolios to inflate their sense of stability.
While some bank officials have called this process subjective, the stress tests have had meaningful impacts. Citigroup – a bank that has failed to meet the Fed’s expectations twice in the past three years – has allocated more resources and employees to make sure that the bank passes. Similarly, Zions Bancorp made necessary precautions to reduce collateralized debt after failing the test last year.
All of these tests have a positive effect on expectations for the economy. As more banks pass these tests – or pass them with greater success – expectations for the economy become more optimistic, which in turn compels greater economic production. By implementing this program (and strengthening it) the Federal Reserve has created a simple and relatively low-cost means to achieve greater economic stability.