Bank Stress Tests: Calling A Mulligan

Are you familiar with the concept of a mulligan? It’s a “do over,” i.e. an activity that erases the results of a previous action when a person performs it a second time.

Amateur golfers often perform mulligans to erase the effects of their damaging physical and mental gaffes. President Bill Clinton, for instance, employed mulligans on golf courses so frequently that commentators began to refer to them as billigans. But who could argue with a President who insisted on the right to replay a poor swing?

Mulligans are permissible in a few other settings as well. The Japanese children’s card game Pokemon, for example, incorporates a “do over” option. And any retailer that permits a customer to return a recently purchased item for a full credit towards a future transaction is effectively offering a mulligan on the initial sale.

So although “do overs” are somewhat rare, they indeed exist in a variety of circumstances. Recently, however, the Federal Reserve Bank of the United States (the “Fed”) decided to institute a mulligan policy in a manner that may raise concerns involving the public interest.

Stress Testing

The Fed’s new policy involves the practice of performing stress tests on global banking institutions. They began to apply such tests in the financial services sector after the global market crash of 2008 and 2009. After American and European governments bailed out the “too big to fail” banking institutions, their regulators began to require the banks to predict whether (and, if so, how) they would survive future economic collapses.

So how do these stress tests function today? On a periodic basis, regulators provide the global banks with theoretical descriptions of future crashes, and require the institutions to develop and defend their own hypothetical plans to survive those crashes. If the regulators determine that a bank’s hypothetical plan is not feasible, they announce to the public that the bank has “failed” its stress test.

Three weeks ago, in the aftermath of President Barack Obama’s Election Day victory, the Fed quietly announced a new “mulligan policy” for such stress tests. But how will this new policy be implemented? And will it serve the public interest?

Failure vs. Success

In accordance with its new policy, instead of simply announcing that a bank has failed a stress test, the Fed now intends to invite the institution to modify its (previously submitted) hypothetical plan in order to retroactively convert its failure into a success. For instance, if a bank had previously indicated that it would plan to maintain its dividend or stock repurchase policy during a crisis, the Fed will now permit it to modify its hypothetical future policy “just enough” to avoid failing the stress test.

It is important to note that the banks are not required to comply with any of their own hypothetical policy statements in the future. If any stressful scenario ever comes to pass, the banks will be free to ignore their prior stress test policy declarations as they see fit. In other words, both their initial “failed” policies and their retroactively defined “successful” policies represent theoretical declarations with no legally binding ramifications.

Therefore, with this new mulligan policy in place, it is difficult to envision any prospective scenario when a global financial institution might fail a meaningful stress test. And thus it is reasonable to wonder whether stress tests will serve the public interest at all in the future.

Pension Policy

A similar degree of skepticism can be expressed about recent policy revisions in the field of pension plan management. Until recently, most pension plan managers abided by the “rule of thumb” that investment asset balances that are available to pay current and future retiree obligations should never fall below 80% of the present value of those obligations.

For instance, imagine a plan that is obligated to pay current and future retirees $100 million in present value terms. Until recently, its managers would have been branded “failures” if they ever permitted the plan’s investment assets to fall below $80 million. And because asset values fluctuate on a day-to-day basis, its managers would (again, until recently) strive to maintain asset balances of $90 to $100 million, so that a traditional “bear market” decline of 10% to 20% could not reduce assets below $80 million.

But when the market crisis of 2008 and 2009 imposed far greater declines on asset values than traditionally experienced in bear markets, this 80% rule of thumb became a more challenging guideline. So how have pension managers responded to this new challenge? They have simply rewritten the guideline; in fact, many now accept coverage ratios of 70% or less.

In other words, stress test bankers and pension plan managers are now redefining “success” and “failure” in a fashion that redefines yesterday’s failures as today’s successes. If measurements of success and failure can be redefined in such a manner, though, what purpose is served by defining these measurements at all?