The Fed's Stress Tests Add Risk to the Financial System

Mar 20, 2013

Til Schuermann Oliver WymanThe Wall Street Journal (March 20) published an editorial by Til Schuermann, a partner at Oliver Wyman's financial services practice, on the viability of the Federal Reserve's annual stress tests for U.S. banks.

While acknowledging some positive aspects of the stress tests, Schuermann, a former senior vice president at the Federal Reserve Bank of New York, noted that, "As the Fed's models have become more and more important in deciding the fate of the biggest banks, those banks have focused more and more on trying to mimic the Fed's results rather than tracing out their own risk profiles. This poses a real risk."

Schuermann also observed that the tests may now be inhibiting innovation by banks:

"The incentives to get close to the Fed's numbers are powerful enough to stifle genuine creativity, imagination and innovation by risk managers and their modelers. Deviating from standard industry practice is now increasingly viewed with suspicion and often discouraged by bank regulators.

I understand this suspicion from my own days at the Fed: The modeling machinery built for the first stress test was in no small part designed to have an independent view on the output of "innovative" but dangerously flawed bank risk models, such as those for mortgage losses. But if everybody uses the same scenario (which they do) and works hard to get the same numbers (and they are trying), then we have a very narrowly specialized risk machine that is inflexible and unresponsive to unexpected shocks. That is, shocks that weren't previously subject to a stress-test."

Read the Wall Street Journal editorial (subscription required)

Oliver Wyman's State of Financial Services 2013 report: A Money and Information Business