Larry Summers just obliterated the Fed's bank stress tests with a single sentence

  • The Federal Reserve’s sees bank stress tests as a key pillar of its post-crisis regulation of large banks.
  • Lawrence Summers, the former US Treasury Secretary and former economic advisor to President Barack Obama, said the idea that all major US banks would be totally fine if economic and financial conditions deteriorate as sharply as some of the tests posit is simply not credible.

Lawrence Summers, the former US Treasury Secretary and former economic advisor to President Barack Obama, takes a dim view of the Federal Reserve’s bank stress tests.

The Fed sees the examinations as a key pillar of its post-crisis regulation of large banks. Ex-Fed Governor Daniel Tarullo, who was in charge of bank regulation during his tenure, once called the tests the most important supervisory innovation of the last 20 years. He also described them as “the leading edge of a movement toward greater supervisory transparency.” Last year, all the country’s major banks passed the tests and then proceeded to splurge on share buybacks and dividends to investors. But Summers, speaking at an event sponsored by the Peterson Institute for International Economics, said the idea that all major US banks would be totally fine if economic and financial conditions deteriorate as sharply as some of the tests posit is simply not credible.

And yet that’s just what happens each time the Fed conducts its periodic stress testing. Here’s what Summers had to say about the tests:

“A stress test that claims that if the Dow falls by 60%, the unemployment rate rises to 12%, housing prices decline substantially more than they did during the 2008 recession, GDP declines by 6-7% – and that all of that can happen and no bank will be in serious financial trouble or have any problem of being undercapitalized or illiquid – I kind of think says more about itself than it says about the health of the banking system.”

“So I think it would be a mistake to suppose that all is well.”

Summers said central bankers should stay humble about their ability to spot and/or moderate asset bubbles, either with interest rates or other tools like leverage limits on particular sectors and other so-called “macroprudential” measures.

“The capacity of central bankers to do that, whether they plan to respond by varying some kind of capital requirement or whether they plan to respond by varying interest rates, seems to be to be very much in question,” Summers said.

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