In 2010, on the heels of the worst financial crisis since the Great Depression, Congress enacted the Dodd-Frank Act. Section 165 of this 849-page law directed the Federal Reserve Board of Governors to develop and apply “stress tests” to large bank holding companies and other financial institutions.
Stress tests are hypothetical accounting and financial modelling exercises that attempt to estimate the impact of adverse economic and financial market developments on the soundness of financial firms. The conduct and implications of these tests have had mixed reviews. Some proponents contend stress tests improve the resilience and stability of the financial system. Critics question whether those tests have been sufficiently stressful, and some even question their utility at all.
Anat Admati, a finance professor at Stanford University and an advocate for significantly higher capital requirements in banking, has called the tests a “charade.” Kevin Dowd wrote an analysis for the Cato Institute titled “Math Gone Mad,” which argues the tests in practice actually “create the potential for a new systemic crisis.”
Banks aren’t the only stressful financial institutions around. The concept of stress testing has spread. The Pew Charitable Trusts, a widely cited authority on pension plans, has been banging the drums especially hard this year. Pew, together with Harvard’s Kennedy School of Government, has developed a set of modelling tools for states to apply in stress tests for their pension plans. A growing number of states has begun to require these tests.
It sure sounds good, on the surface. Why not subject these risky pension plans to rigorous scrutiny? Isn’t that a responsible thing to do?
In practice, however, stress tests have the potential to bias risk allocation in ways preferred by well-organized special interest groups, at the expense of citizens, taxpayers, and the Average Joe and Jane.
Take a peek at a lengthy paper Pew issued a few months ago. Titled “Assessing the Risk of Fiscal Distress for Public Pensions: State Stress Test Analysis,” Greg Mennis, Susan Banta and David Draine reported on the results of applying their tests to public pension plans in 10 states, and recommended that stress tests become a standard reporting practice for all public-sector retirement systems.
Consider who they stressed, however. The title may have been subtitled “State Stress Test Analysis,” but states weren’t the organizations being stressed. The pensions were the object of the analysis.
Improving the stability of pension finances may reduce risks for state government operations and taxpayers. However, focusing on pensions and reducing plan risk can also come at the expense of, and pose higher risk to, other government operations, as well as taxpayers and citizens.
In their May 2018 paper, for example, Mennis, Banta and Draine praise Wisconsin and North Carolina for demonstrating “how strong funding policies can help to ensure that public pension systems are sustainable and secure.” Wisconsin and North Carolina certainly rank high on their pension funding status, among the 10 states covered by Pew as well as nationally. However, in our holistic analysis of state financial conditions, Wisconsin and North Carolina’s overall financial position don’t rank nearly as high as might be expected given the pension funding because bond borrowing debt runs relatively high in those states.
This can illustrate how a state might strategically work harder to improve its performance in pension stress tests, but at the expense of the general public. Consider what happens when a hypothetical state issues a bond, a bond so large that it leads its funded ratio to rise to 100 percent. The risk to the pension plan has certainly gone down, but the risk for the rest of the state government as a whole has increased.
Chicago is now considering a massive new bond offering designed to fund its woefully underfunded pension obligations. City leaders are reportedly briefing city aldermen ‘behind closed doors.’ The bond offering would certainly improve Chicago pension plans’ odds of passing stress tests. But it would also increase the size and risk of the city’s overall balance sheet.
Stress tests can be abused. If they can be applied honestly, they should focus on the right entity, not a special, favored subset of government.