By James Kwak

There is a common phenomenon in legal disputes over the value of something, be it a company, a piece of land, or a person’s expected lifetime earnings. Each side hires an “expert” who produces an estimate based on some kind of model. And miraculously, every single time, the expert for the party that wants a higher number comes up with a high number, while the expert for the party that wants a lower number comes up with a low number. No one is surprised by this.

Yesterday, the Federal Reserve posted the results of the latest periodic bank stress tests mandated by the Dodd-Frank Act. For these tests, the Fed comes up with various scenarios of how things could go badly in the economy, and the goal is to see how banks’ income statements and balance sheets would respond. The key metrics are the banks’ capital ratios; the goal is to identify if, in bad states of the world, the banks would still remain solvent. If not, the banks won’t be allowed to do things that reduce their capital ratios today, like paying dividends or buying back stock.

For the most part, the results look pretty good: capital levels even under the severely adverse scenario should remain above the levels reached during the 2008–2009 crisis. (Of course, there are several huge caveats here. You have to believe: first, that the scenarios are sufficiently pessimistic; second, that the banks’ current financials are accurately represented; third, that the model is sensible; and fourth, that the capital levels set by current law are high enough.)

But there’s something else going on here. As part of the stress testing routine, each bank is supposed to do its own simulation of how it would respond to the scenarios specified by the Fed, using its own internal model. And—surprise, surprise!—the banks virtually uniformly predict that they will do better than the Fed.

At the high end, Goldman Sachs and Citigroup predict that they would have capital levels 3.9 and 3.0 percentage points, respectively, higher than expected by the Federal Reserve. Since the Fed predicted minimum Tier 1 capital levels for these two banks of 6.8 and 7.0 percent, those are huge differences: 57 percent higher for Goldman and 41% higher for Citi. The other four big banks also claimed their capital levels would be 0.2 to 2.6 percentage points higher than in the Fed’s model.

Now if everyone were being above board here, the expected difference between the banks’ estimates and the Fed’s estimates should be zero. But of course that’s not the case. Banks do things to make money, and in this exercise their goal is to make the case that they can get by with less rather than more capital. There are honest differences of opinion on how to model things, but you can systematically make plausible choices that produce higher rather than lower numbers. And that’s almost certainly what’s going on. Which means that the banks’ estimates aren’t worth the electrons who died (OK, not literally) sending them to you across the Internet.

But, you may be thinking, isn’t the Federal Reserve systematically trying to produce low numbers? Not necessarily. The Fed’s incentive in the first instance isn’t to force banks to maintain more capital; it’s to make sure that banks are holding the right amount of capital. The Fed is supposed to protect the financial system and ensure economic growth, so if you believe in the capital-growth tradeoff, the Fed doesn’t have an incentive to force banks to hold lots of capital. (And if you don’t believe in it, then you should already agree with Admati and Hellwig that every bank should have lots more capital.) In other words, Fed economists don’t make any more money by arguing that banks need more capital.

Although there’s no a priori reason why the Fed as an institution would want banks to hold more capital, it’s also possible that the specific people at the Fed do think that banks should be holding more capital, and they are using the stress tests as a backdoor way to push that agenda. But if that’s the case, there’s another, more powerful tool they should be using: they should be boosting the leverage ratio (which, counterintuitively, is  measured as equity over assets, not debt over equity).

Finally, this whole thing proves a point that I argued a long time ago: capital doesn’t exist as an object in the world. It’s inherently probabilistic, since it is based off of the values of things whose value depends on unknown probability distributions. That’s why it’s possible for Goldman to argue with a straight face that its capital will be 57 percent higher in some state of the world than the Federal Reserve thinks it will be. And that’s why, if you’re counting on capital requirements to protect the financial system from disaster, you had better err far on the side of safety.

14 responses to “Skew

  1. When the banks and the FED do this sort of analysis, do they use monte-carlo type statistical analysis methods? I would assume that there is some variation in the assumptions used. I’m an engineer and we use some sophisticated models to predict outcomes with variations on inputs. It would seam reasonable to expect that the statisticians doing this modeling are?

  2. Should they be Ian? I would test the veracity of their gold as to how well banks are capitalized these days.

  3. The banks committed massive fraud and lies and we found out in 2008. Then, we discovered rigged markets from foreign currency exchanges to LIBOR afterwards. If the banks can lie with a straight face in good times and bad even to the legal system, how can we trust these results since they are mathematical models that can be gamed as James Kwak says by adjusting the parameters. It’s just another fancy lie.

  4. Per Kurowski

    Talk about “skewed”! “Perceived risk aversion”!

    Here Baseline Scenario, more than six years into the crisis, does still not understand that more important than what is on the balance sheets of the banks, is what is not in there.

    Like all those loans to medium and small businesses, entrepreneurs and start ups which were not given because banks then had to hold much more capital.

  5. And to think Per, those same medium and small people would rather hold on the the debt, than let a market maker solve their problems. This is fine as long as rates stay low, but if they somehow rise, for some strange reason, that will prove to not be, a prudent move.

  6. Per Kurowski

    I just tell you that bank regulators who only concern themselves with the assets that are on the books of the banks, show they ignore the fact that banks have a vital role to play in the allocation of bank credit to the real economy.

  7. Big gap in fed methodology is assuming that bank balance sheet will grow in severly adverse scenario which is counter to what happens. So Pre provision earnings and loss are higher in fed estimates

  8. Rather than read the tedious, trite posts at Baseline Scenario, spend 23 minutes listening to an actual scholar of banking;

    There’s more useful information in the above audio than in all the BS posts combined over the years (with regard to banking).

  9. Still the same problem, Paddy. No regulation to enforce the “scholarly” banking system, except for the fraud part, it seems….plenty of regulating was used by fraud.

    “….money for nothing and the chicks are free….”

    When people reach into the future, why is it that everyone is seeing what kind of planet comes next when not a single good soul from “middle class” USA is left to provide profit on the money issued as debt….visions of planet blowing itself up when the War, Drug and Slave Lords feed off each other – the “final” war – right? Just like the “prophets” predicted…..

    “Everything” was on the books, Per. Someone still keeps the double-entry bookkeeping ledger, don’t they?

  10. Come on guys, are we running out of places to hide? Stick around cause the good stuff don’t get published till later.

  11. John Merryman

    The reality and the fallacy of capitalism, is that money is a contract, yet it’s essentially treated as a commodity. It is always a debt, ie. a contractual obligation on someone else’s part and when this relation gets ignored and the ability of the counterparty to fulfill that obligation gets increasingly tenuous, bad things happen.

  12. Per Kurowski

    In a remake of “The Graduate” Dustin Hoffman, instead of “plastics”, would have to be recommended “bank regulations”

  13. Bruce E. Woych

    Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (The Princeton Economic History of the Western World)
    by Charles W. Calomiris (Author), Stephen H. Haber (Author)
    (from the review)
    “Why are banking systems unstable in so many countries–but not in others? The United States has had twelve systemic banking crises since 1840, while Canada has had none. The banking systems of Mexico and Brazil have not only been crisis prone but have provided miniscule amounts of credit to business enterprises and households. Analyzing the political and banking history of the United Kingdom, the United States, Canada, Mexico, and Brazil through several centuries, Fragile by Design demonstrates that chronic banking crises and scarce credit are not accidents due to unforeseen circumstances. Rather, these fluctuations result from the complex bargains made between politicians, bankers, bank shareholders, depositors, debtors, and taxpayers. The well-being of banking systems depends on the abilities of political institutions to balance and limit how coalitions of these various groups influence government regulations.
    Fragile by Design is a revealing exploration of the ways that politics inevitably intrudes into bank regulation. Charles Calomiris and Stephen Haber combine political history and economics to examine how coalitions of politicians, bankers, and other interest groups form, why some endure while others are undermined, and how they generate policies that determine who gets to be a banker, who has access to credit, and who pays for bank bailouts and rescues.”