Santander Holdings and Deutsche Bank emerged as two major banks that failed to meet standards in the Federal Reserve’s annual stress testing of some 30 major U.S. banks.

“On one level it’s not surprising because we’ve imposed some new regulations on international subsidiaries that are requiring them to hold more capital,” said Andrew Metrick, professor of finance with Yale University in New Haven, Connecticut.

“It’s not that they are in trouble but they need to store more of their capital domiciled in the U.S. because we want the organizational forum to be more robust domestically.”

If federal stress testing has become a year round supervisory mechanism, it’s not entirely a negative development because testing keeps banking executives on their toes.

“When you weigh the total cost of all stress testing and measure that against the total cost of the Great Recession since 2008, you realize that one ounce of prevention is worth it because stress tests force banks to look at and change their lending behavior and capital planning,” said Ed Robertson, managing director with Situs, a firm that helps financial institutions meet regulatory and compliance requirements.

Originally, stress tests were designed to be management and screening tool, which is a step up from static bank valuations that existed before the Dodd Frank Act Stress Test, which requires national banks and federal savings associations with total consolidated assets of more than $10 billion to submit to annual testing in the form of scenarios.
 
“Stress test shouldn’t be taken at face value but rather should be used as a range of output results,” Robertson told Newsmax Finance.

But stress testing isn’t perfect. For one thing, the cost benefit is unclear to some.

"The downside of stress tests becoming a year round supervisory tool is the cost and the tendency to trust the results too much, which gives regulators and bank executives a false sense of security,” said Anat R. Admati, a professor with Stanford University and author of The Banker’s New Clothes: What’s Wrong with Banking and What to Do About It (Princeton University Press 2014). “We need to supervise but how to do it effectively is the question.”

“Contagion risk has to do with the system being very connected and highly correlated so that it’s more likely to fail at the same time,” Metrick told Newsmax Finance. “That’s a scenario that stress tests can not measure because of the many layers of interconnectedness.”

However despite imperfections, the process of stress testing itself is important and valuable because it gives regulators insight and helps guide them.

“Regulators are not striving for perfection,” said Timothy McTaggart, partner with Pepper Hamilton and former bank commissioner with the state of Delaware. “They look at qualitative factors not just quantitative ones so even if they have the wrong variable in the quantitative model, they do a good job in terms of ferreting out qualitative issues and respond with the right supervisory action.”

Juliette Fairley is an author, lecturer and TV host based in New York. To read more of her work, Click Here Now.