Fed puts Wall Street under stress

The Federal Reserve is twisting Wall Street’s arm and it’s not letting up.

The central bank is flexing its muscle over the banking sector with annual “stress tests” that run a bank’s financial books through various scenarios to determine whether it can withstand a financial shock.

{mosads}The tests have become a source of major anxiety for the financial industry, because banks that do not pass cannot institute investor rewards such as dividend payments or stock buybacks. Banks that fail can resubmit modified plans to gain Fed approval, however.

The latest round of “stress” came in March, when the Fed tested 30 capital plans and rejected five of them, including one put forward by Citigroup, the nation’s third-largest bank.

“This latest round of stress tests tends to show that the Fed’s no pushover,” said David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution. “The fact that the banks are doing a little yelping is probably good for the Fed’s reputation as a tough overseer.”

Ever since the financial collapse, the Fed has made a habit out of running a bank’s finances through the paces. Under the most recent stress test, the Fed looked at how banks would perform if unemployment jumped to 13 percent, equity prices were halved and housing prices plummeted by 21 percent.

But the Fed took its latest test beyond that number crunching, rejecting four bank plans on qualitative grounds. While Citigroup’s plan withstood the economic downturn on paper, the Fed said it had concerns about the “overall reliability” of its capital plan.

The Fed’s decisions carry enormous weight on Wall Street. After Citi’s plan was rejected, its stock price took a nosedive to 5 percent, and it has remained at that level since then.

Eugene McQuade, Citibank’s chief executive who was on the verge of retirement, has reportedly planned to postpone his exit to oversee the bank’s next submission of a capital plan, with the intent of getting the right result.

The takeaway from the tests, observers say, is that the Fed is willing to use its powers broadly to impress its concerns upon the banks.

“It really gives the Fed a huge opening here to do whatever they want,” said Paul Kupiec, a former bank regulator with the Federal Deposit Insurance Corporation who is now at the American Enterprise Institute. “It gives them almost complete discretion.”

The Fed has long exerted control over the levers of the economy, with every utterance about interest rates dissected for hints about where the central bank might next try to steer monetary policy.

But the Fed also doubles as a bank regulator, and, like other financial overseers, was subjected to a fair amount of second-guessing after the financial crisis.

As a regulator, the Fed has always had the power to monitor a bank’s activity and point it in a different direction. But the modern stress tests place a new spotlight on that effort, as every bank is immediately, and publicly, compared to other major institutions when the results are released.

Add to that the fact that there is a layer of ambiguity for banks trying to pass the stress test, and it has emerged as a potent tool in the Fed’s arsenal.

“Clearly the banks are saying, ‘Give us the rules and give us the road map and we’ll color in each one of the little ovals on the standardized tests,’ ” said Wessel. “The Fed is saying, ‘We don’t want to make it that simple.’ ”

Detractors of the stress tests say giving or denying banks a seal of approval could send the wrong message if the Fed’s models prove insufficient when a real crisis hits.

“There’s not a lot of science going on. There’s a whole lot of judgment going on,” said Kupiec. “The jury’s still out about whether they have any ability to anticipate the banks that might actually get into trouble.”

For its part, the industry is publicly focusing on the positive results. After all, most banks passed their stress tests with flying colors.

“Regulators threw every economic calamity they could think of at our nation’s largest banks, and these institutions once again proved their ability to handle even the most extreme financial distress,” said Frank Keating, head of the American Bankers Association, when the results were released.

Stress tests entered the Fed’s portfolio of powers shortly after the financial crisis. At the time, regulators were eager to test the banks’ reworked books, and to communicate to the market that those financial giants were not going to be the next to topple or get a bailout.

While the first stress test found some banks needed to raise billions to weather another crisis, it was actually seen by many as a boon for the markets and the economy, as the first real vote of confidence from the government in the financial sector.

Stress testing is now codified as part of the Dodd-Frank financial reform law, meaning banks can expect the check-up every year into the foreseeable future.