How bank stress tests are like restaurant inspections
The results of the Federal Reserve’s annual stress tests resulted in a failing grade for European banks Deutsche Bank and Santander, a pass — after some extra credit — for JP Morgan Chase, Morgan Stanley and Goldman Sachs, and a do-over for Bank of America.
The grades are a bit like those handed out to restaurants by health inspectors.
One difference is that banks know when the inspectors are coming. But Kent Smetters, professor of business economics and public policy at Wharton, says this isn’t a problem, because banks can’t easily change — and then change back — the basic riskiness of their balance sheets.
This years’ tests did ding Bank of America for “certain weaknesses” in its processes and controls.
“It would be similar to going to a restaurant and saying the food tastes good, the service is fine, and then you walk back in the kitchen and you see somebody is using their hands with fingernails that are unclean,” says Mike Mayo, bank analyst at CLSA.
But while these kinds of offenses might shut down a local restaurant, Simon Johnson, professor of entrepreneurship at the MIT Sloan School of Management, says that because banks are so systemically important, regulators tend to treat them with “kid gloves” — but that complexity also means their risks are very difficult to accurately “grade.”
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