Banking's Final Exam: Stress Testing and Bank-Capital Reform

Banking's Final Exam: Stress Testing and Bank-Capital Reform

by Morris Goldstein


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Spurred by the success of the first stress test of US banks toward the end of the global economic crisis in 2009, stress testing of large financial institutions has become the cornerstone of banking supervision worldwide. The aim of the tests is to determine which banks are adequately capitalized under severe economic shocks and to order corrective measures for those that are vulnerable. In Banking’s Final Exam, one of the world’s leading experts on banking regulation concludes that the tests administered on both sides of the Atlantic suffer from fundamental weaknesses, leading to a false sense of reassurance about the safety and soundness of the banking system. Some weaknesses can be corrected within the existing bank-capital regime, but others will require bold reforms—including higher minimum capital requirements for the largest and most systemically-important banks. The banking industry is likely to resist these reforms, but this book explains why their objections do not hold water.

Product Details

ISBN-13: 9780881327052
Publisher: Peterson Institute for International Economics
Publication date: 05/30/2017
Series: Policy Analyses in International Economics , #105
Pages: 350
Product dimensions: 6.00(w) x 8.90(h) x 1.10(d)
Age Range: 18 Years

About the Author

Morris Goldstein, nonresident senior fellow at the Peterson Institute, has held several senior staff positions at the International Monetary Fund (1970–94), including Deputy Director of its Research Department (1987–94). From 1994 to 2010, he held the Dennis Weatherstone Senior Fellow position at the Peterson Institute. He has written extensively on international economic policy and on international capital markets.

Table of Contents

Preface xi

Acknowledgments xv

Abbreviations xvii

Introduction: Scene Setting, Preliminaries, Outline, and Main Findings 1

Setting the Scene 1

Preliminaries: Measurement of Bank Capital, the US Comprehensive 4

Capital Analysis and Review, and the Dodd-Frank Act Stress Tests Outline of the Study 9

Main Findings 14

Appendix 1 Event and Impact Studies of US and EU-Wide Stress Tests 33

1 Why Were the EU-Wide Stress Tests Not Better Received? 39

Weak Supervisory Authority 39

No Critical Mass on EU Banking Union, and a More Serious Too Big to Fail Problem 39

A Weak Supporting Crisis Management Cast 40

Higher Outside Estimates of Capital Shortfalls 43

Poor Design of the EU-Wide Stress Tests 46

Appendix 1A Indicators of Too Big to Fail in EU and US Banks 65

Appendix 1B The Weak Supporting Crisis Management Cast for the EU-Wide Stress Tests 67

2 Operational Features and Evolution of the US and EU-Wide Tests 77

Operational Features 77

Evolution of Stress Testing, 2009-16 97

3 Criticisms of Stress Testing Methodology and the Measurement of Bank Capital 103

Stress Tests as Poor Early Warning Indicators of Banking Crises 103

Failure of Stress Tests to Capture the Dynamics of Actual Financial Crises 107

Shortcomings of Risk-Weighted Measures of Bank Capital 119

4 What We Have Learned-or Should Have Learned-about the Right Level of Bank-Capital Ratios 135

Bank Losses during the 2007-09 Crisis 137

Macroprudential Approach to Banking Supervision 152

Benefits and Costs of Much Higher Bank-Capital Requirements 155

Conclusions 174

5 Estimating Capital Surcharges for Global Systemically Important Banks 187

Capital Ratios Relative to Systemic Importance Indicators for G-SIBs versus Non-G-SJBs 187

The Bank of England's "Symmetry and Proportionality Approach" 205

The Federal Reserve's "Estimated-Impact" Approach 228

Conclusions 240

6 Lessons from the US and EU-Wide Tests 247

7 A Plan for Bank-Capital Reform 257

Outline of the Plan 258

Features of the Plan 259

Advantages of the Plan 273

8 Potential Objections to the Plan for Bank-Capital Reform and Closing Remarks 285

10/11-13/14-18 Percent Minimum Leverage Ratios: A Step Too Far? 285

Large Banks, Larger Banking Systems, and Too Little/Too Much Finance 290

Shadow Banking and the Migration Problem 297

Are Higher Equity Minimum Capital Requirements Still Needed After TLAC? 307

Closing Remarks 317

9 Postscript 325

The Trump Administration and Financial Deregulation 325

Next Steps for the US Stress Tests 330

References 339

Index 363


1.1 Cost of US federal government response to the financial crisis 41

1.2 Actual and projected recovery to previous real GDP peak in the euro area 44

1.3 Risk-weighted capital ratios and leverage ratios for large EU banks 53

2.1 US bank stress tests, 2009-16 78

2.2 EU-wide bank stress tests, 2009-16 84

4.1 Basel III minimum requirements and phase-in arrangements 136

4.2 Summary of the estimates of implicit too big to fail subsidies 163

4.3 Profitability of major global banks 165

5.1 Global systemically important banks, as of November 2015, allocated to buckets corresponding to required level of additional loss absorbency 189

5.2 Risk-based capital surcharges for US global systemically important banks 190

5.3 Systemic importance indicators reported by large US bank holding companies 191

5.4 FDIC Global Capital Index, December 31, 2015 194

7.1 Leverage ratio targets and implied adjustments for G-SIBs, non-G-SIBs, and small banks 262

7.2 Leverage ratios for US G-SIBs: Starting position and implied adjustments for 10-year phase-in 263


3.1 Risk-based capital ratios and leverage ratios for major global banks, end-2006: Surviving banks versus failed banks 121

4.1 Lending spreads in selected economies, 2007-14 166

4.2 Ratio of bank credit to GDP, 2006 and 2013 167

4.3 Occurrence of banking crises 172

5.1 Tier I leverage ratios 193

5.2 The critical risk weight 206

5.3 Commercial bank two-year loan loss rates, 1921-2008 216

5.4 Net income for US and EU banks, 2006-13 218

8.1 Estimated scale economies 291

8.2 Shadow banking and traditional banking in the United States, 1960-2014 299


3.1 Financial-sector interdependence and contagion risk 113

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