More Stress Is Path Forward for New Bank Rules

In an important speech last week, Federal Reserve Governor Kevin Warsh found something that both parties can agree on when it comes to fixing the financial system.

Embattled Treasury Secretary Timothy Geithner should e-mail Warsh's speech to his colleagues before financial reform, like health reform, spins out of control.

The basic message from Warsh, who was appointed to the Fed in 2006 by George W. Bush, was that any overhaul to how the financial system is regulated should lock in policies that we know work. To date, Democratic proposals have failed to do that. Instead, they have relied on blind faith in a massive expansion of vague government power.

If stress tests can create confidence in the middle of the worst financial crisis in generations, then they should be able to do so year in and year out.

President Barack Obama's economic team had at least one commendable success last year. The turning point in the Great Recession occurred last May, when Geithner announced the result of the government's stress tests of the 19 largest U.S. banks.

The tests, recall, were an intensive effort to sift through the gobbledygook and identify exactly how bad bank balance sheets were. Small armies of economists and regulators descended on our major financial institutions, looked under every rock, and then evaluated which banks were likely to live, and which were not.

The stress tests drew no shortage of criticism and were viewed as a giant gamble for Geithner. Washington waited for the results with the same dread experienced by cancer patients after a biopsy. Economist Nouriel Roubini asserted that U.S. banks were insolvent. Economist Paul Krugman argued that the banks would have to be nationalized. Senior members of the Obama economic team were thought to hold similar views.

Happy Surprise

Then a funny thing happened when the results of the tests were announced: The banks were in much better shape than most anyone expected. This set the stage for a rebound of confidence in the financial sector and for private capital again to flow. Geithner's gamble had paid off.

The success of the stress tests highlighted how profoundly inadequate our financial regulators were. If they had been doing their jobs, the success of the tests would not have been news. Markets would have known that banks were fine, because regulators said that they were.

Current Democratic proposals call for more regulators. Why should the new guys be any better?

The stress tests also highlighted problems with the level of information banks must disclose. Until then, analysts lacked sufficient information about balance sheets to evaluate the general health of the banks. Only the stress tests dug deeply enough to provide what investors really needed to know.

No Mention

Given that success, we might have expected that financial reform would be centered on the stress tests. Instead, there has been almost no reference to them at all. The president and congressional Democrats are racing forward with plans for sweeping new regulatory powers. There is talk of limiting the size of banks or constraining what they do.

In his speech, Warsh observed convincingly that such a focus is unlikely to deliver results.

"If real reform were chiefly about the number of financial regulators in Washington--or even the precise relationships between financial regulation and the role of the central bank--we should find an institutional design among major financial centers around the world that lived up to its promise," he said. "We find no such example."

Faith in Facts

Rather than put our faith in bureaucrats, Warsh added, why not trust the facts? If balance sheets are made public with sufficient detail, stress tests can be performed routinely. Then banks will have a strong economic interest to avoid risky behavior, and regulators and investors will have the information they need to see train wrecks coming months or years in advance.

In other words: If stress tests can create confidence in the middle of the worst financial crisis in generations, then they should be able to do so year in and year out.

This suggests two possible reform paths, both radically different from current proposals.

We might consider institutionalizing the financial SWAT teams that performed the stress tests and regularly requiring firms to open up their books to them.

Or, we could require firms to provide reports to the public that are similar in detail to what was required for the stress tests.

Democrats, one might suppose, would prefer the former solution, Republicans the latter. But either would irrefutably be a step in the correct direction.

Start with Success

If Obama and the Democrats want to change the mood in Washington, they should start with financial reform. Warsh's speech sketches a plan based on common sense and experience that would rely on what already worked. It is hard to imagine any sensible person opposing reforms based on that sketch. Why not invite Republican and Democratic lawmakers, working together, to draw up a simple reform that provides the public with regular stress tests?

Usually, politicians remind us endlessly of their successes. That makes it all the more puzzling that Obama and his team have failed to base their reform proposals on their biggest success of 2009.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI.

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