Bank stress tests are like Monopoly, says one former banker. 'Do not mistake either for reality.'

By Steve Goldstein

One former banker says bank stress tests are essentially worthless exercises after the Federal Reserve gave passing grades to all 31 institutions it tested.

The Fed's stress tests released late Wednesday showed U.S. banks passing after absorbing $685 billion in hypothetical losses, in a severe global recession scenario with a 40% decline in commercial real estate prices and a 36% decline in house prices. A separate test where five large hedge funds collapse, found losses of between $70 billion and $85 billion.

See MarketWatch's coverage of stress-test results.

"My greatest contribution to the bank capital industry was drawing up a pretty spreadsheet explaining the subordination ladder, Tier 1, 2 and 3 capital, and how these related in spread terms", wrote Bill Blain, market strategist at Shard Capital, who spent half his markets career as a financial institutions banker at Bear Stearns and HSBC.

"Bank stress tests are fun. They are interesting. So is a game of Monopoly. Do not mistake either for reality," said Blain, adding that the current stress tests are a "tickbox."

"Sadly... the reality remains: a) regulators plan to address the next financial crisis by understanding and planning to fight the last one, b) financial crises keep repeating, but no two crises are alike, and c) risk is not a constant, it is constantly changing dynamic," he said.

Here's what he says makes stress tests meaningless:

"Consequences - you can set scenarios, but in the real-world unanticipated consequences make it impossible to fully model outcomes," he writes.

Another is that risk is dynamic. "It can't be destroyed, only transformed or transferred. It changes and does not go away," Blain says.

Importantly, banks die quickly, not slowly. "Liquidity crises kill banks swiftly. They don't get 9 months to unravel positions from plentiful capital reserves," says Blain.

Relatedly, confidence in banks is ephemeral. "It has a half-life measured in nano-seconds when it starts to go wrong, and when it goes critical it can't be reversed.. witness Lehman and Credit Suisse. Decades apart. Both died because the market lost confidence," says Blain.

-Steve Goldstein

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06-27-24 0458ET

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