Banks have been grumbling about the Fed’s stress tests since, well, since the Fed came up with the idea of stress tests in the wake of the financial crisis: They’re too hard. They’re arbitrary and unfair. They’re running our banks for us. They hurt our feelings.

They hurt their feeling so much, in fact, that they’re even thinking about suing over it, which is a pretty drastic step, given all of the things the Fed can do to banks that displease it. But if they did sue, they’d win, according to the Harvard law professor the banks hired to tell them they’d win.

“We find that the Federal Reserve has likely not complied with the [Administrative Procedure Act’s] procedural requirements in adopting key aspects of its Comprehensive Capital Analysis and Review stress tests,” the paper says. Following those requirements “would result in better public policy outcomes and reduce the threat of a legal challenge to the Fed’s actions….”

The paper says two aspects of the tests—the assumptions the Fed makes about future scenarios and its mathematical models to project how banks will fare under the scenarios—“function as rules” because they effectively dictate the amount of equity capital banks must maintain. The Administrative Procedure Act generally requires agencies to publish drafts of their rules for public comment, but the Fed doesn’t publish drafts of the scenarios or models.

Those sorts of ideas seem to be flying around Cambridge these days, because certain Harvard presidents/Treasury Secretaries emeriti is also chiming in. Larry Summers’ verdict? All that heavy lifting has been for naught.

“To our surprise, we find that financial market information provides little support for the view that major institutions are significantly safer than they were before the crisis and some support for the notion that risks have actually increased,” Ms. Sarin and Mr. Summers wrote….

In the paper, the economists say their findings “suggest cause for concern that there is a nontrivial probability of at least a major loss in equity value by a major institution sometime in the next few years,” they wrote.

The authors attribute this primarily to the fact that the franchise value of most banks—specifically, the ratio of their stock price to book value and the market value of equity to assets—has declined substantially since the financial crisis.

Is Larry Summers, deregulator-turned-re-regulator, feeling some belated Bern and looking for reasons to blow up the banks? Not exactly.

“There is a possibility that by further eroding bank franchise value, further regulatory actions could actually increase systemic risk,” they say.

Banking Group Finds Fed Stress Tests Likely Illegal [WSJ]
New Laws Haven’t Made Big Banks Safer, Paper by Lawrence Summers Says [NYT]