Major Banks Pass Stress Test: Was it Stressful?

The New York Times announced today that the nation’s biggest banks, according to certain “stress” tests, appear to be able to survive a serous downturn in the economy, where housing and securities markets severely decline and unemployment rises to 10%. Whether passing the stress test equates to a clean bill of heath for surviving the next serious recession depends on the metrics used to measure the banks’ health under various scenarios. Does that mean we are relying on the “quants” for the proper metrics, the math wizards who were lured away from math and scientific pursuits to help Wall Street create exotic and complicated investment products in the last 15 years? Yes. Remember that quants and their metrics gave Wall Street the cover it needed to classify risky housing securities products as investment grade, resulting in billions in losses for investors in the housing bust. It turned out the models the quants used were flawed: for one thing they sometimes didn’t go back far enough in financial history in building assumptions for the models. The banks’ passing the stress test is only as meaningful as how the stress test models are built, and we are once again in the hands of the financial quants in making that determination.