The Future Costs Of Regulators’ Proposed Banks Stress Tests Are Worth It

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The decision by the Federal Reserve, the FDIC and the Office of the Comptroller of Currency (OCC) to finalize its guidance for bank stress tests focusing on their risk management practices within days of JPMorgan’s (NYSE:JPM) $2 billion trading loss hardly looks like a coincidence. [1] Last June, regulators proposed these stress tests for all banking institutions with more than $10 billion in consolidated assets.

These tests are proposed to be carried out by banks in addition to those laid out in the Dodd-Frank Act as well as those conducted by the Fed every year to monitor the capital plans of the biggest banking institutions. The move is yet another step towards dissuading banks from taking untoward risks in a bid to make quick money. Incidents like the one at JPMorgan and the one reported by UBS (NYSE:UBS) last year have only helped regulators hasten the implementation of stricter guidelines for banks.

See our full analysis for UBSJPMorgan

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The regulators propose scenario-based stress tests to be carried out at various levels by all financial institutions with more than $10 billion in assets – excluding community banks. While banks are likely to protest having to undergo yet another stress test, the fact that this is coming in the wake of this massive trading loss means that it will likely face very little resistance otherwise. These tests aim to provide a clearer picture of a banking institutions’s exposures and risks. Additionally, the tests would also assess the strength of the bank’s internal controls.

The new set of stress tests definitely bring in an added level of transparency to the functioning of banks – more specifically to the larger, ‘too big to fail’ banks. This will, no doubt, come at a cost to the banks.

The most direct impact would be an increase in monitoring and compliance costs, as all banks which come under the purview of this law will need to allocate resources to conduct the stress tests – something which the regulators themselves estimate would need about 460 hours per bank at least. And there will be significant costs involved in beefing up internal controls if found deficient by the tests. This would impact operating margins for banks.

But banks would be more worried about the bigger, indirect impact of these tests. Every bank has risky trading assets on its balance sheet – some more than the others – and these assets potentially generate higher yields for the bank. If the stress tests suggest that a bank has more risky assets than deemed normal, the regulators will most likely step in to force the bank to cut down on such assets. This will reduce the rate of growth in that bank’s trading assets, while also driving down trading yields – both factors potentially dragging down trading revenues by a large value.

To better understand the impact of a reduction in trading assets and trading yields on JPMorgan’s total value, you can make changes to the charts above.

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Notes:
  1. Agencies finalize large bank stress testing guidance, Federal Reserve Website, May 14 2012 []