Peterson Institute Publishes New Book on Stress Testing and Bank-Capital Reform

Washington—A new book published by the Peterson Institute for International Economics finds that financial regulatory authorities around the world need to do far more to strengthen the global banking system’s defenses against future financial crises. In Banking’s Final Exam: Stress Testing and Bank-Capital Reform, Morris Goldstein concludes that despite improvements to the quantity and quality of capital in recent years, bank-capital requirements and stress tests currently conducted in the United States and the European Union still fall far short of what is needed to sufficiently increase financial stability. Goldstein, a renowned expert on financial systems and regulations, and a longtime senior fellow at PIIE, marshals a large body of evidence to show that minimum and actual capital ratios for the largest and most systemically important US banks remain too low. He further argues that the metrics used in today’s stress tests do not adequately gauge systemic risk or even distinguish sick from healthy banks. In addition, he argues that the contagion and amplification of financial shocks that played a decisive role in the global financial meltdown of 2008–09 are still not properly integrated into today’s stress tests.

also puts forward a sweeping plan for bank reform to be implemented over a ten-year period—first in the United States and, if successful, then globally. His proposal calls for minimum tangible leverage ratios (the highest quality of bank capital) to be set at 14 to 18 percent for the eight US banks deemed to be globally systemically important (G-SIBS), at 11 to 13 percent for other large banks (those with total assets greater than $50 billion), and at 10 percent for smaller banks. Such an increase in minimum bank-capital ratios would increase the banking sector's capacity to absorb the blow of another major financial crisis and reduce the chances of a future taxpayer bailout. The plan would also combine these much higher minimum leverage ratios with a risk surcharge based on a set of indicators.

The book’s proposals would make the regulatory system easier to understand, less costly to maintain, and less susceptible to manipulation by large banks, according to the author. And because the difference in minimum capital ratios between G-SIBs and other banks is much greater under this plan than under current regulations, banks that are too big to fail would be incentivized to shrink over time to avoid these larger capital requirements. Finally, Goldstein offers evidence that, contrary to the doomsday claims of the banking industry, the plan outlined in the book would be consistent with healthy bank lending and with satisfactory US economic growth.

“Financial regulators around the world should take seriously Morris’s warning that the current framework of stress tests and capital requirements are inadequate. His bold recommendations for building a more robust banking system and for eliminating taxpayer bailouts of too big to fail banks have much to commend them.” says Adam S. Posen, PIIE president. “The current international and domestic regulatory framework is disjointed, and as a result, we are not yet safe from risks taken by the world’s largest banks. Raising highest quality capital requirements to the levels Morris proposes and improving stress testing could address the ongoing policy problem of handling systemically important institutions.”