You may not know that there’s a new round of stress tests for the banks on the horizon. The Federal Reserve announced these stress tests late last year, designed to determine whether the banks could handle another downturn. The last stress tests were plagued by actual bargaining between the administrators of the tests and the banks to get them to a relatively healthy position. They simply weren’t a real assessment of the health of the banks. Similarly, these tests probably won’t include any contingency for mass putbacks of soured mortgages by investors, for example. Therefore, these stress tests won’t be entirely legitimate either. But DealBook says it’s much worse than that:

This set of exams, announced in November, is Son of Stress Test 2009, a followup to tests the Fed conducted in the wake of the financial crisis.

But something seems different this time around. It’s almost as if the banks knew their results, even before the testing was complete.

Since the end of last year, banks have been bragging about their rude health. Bank of America’s chief executive, Brian T. Moynihan, suggested that the bank would raise its dividend above its current token amount. Jamie Dimon, JPMorgan Chase’s leader, did the same. Warren E. Buffett suggested in his shareholder letter that Wells Fargo was about to pass with flying colors.

Of course, banks ought to have a good idea of the results. They came up with the questions — and the answers.

The Fed gave the banks one economic assumption — a recession — to test their books against, but otherwise the measures were chosen by banks themselves. The Fed just vetted them. Seems like a low bar.

I’ll say!

This is like doing a math test where you wrote the questions, you have a calculator and the answer sheet, and you can spend a few months finishing it from home. The Fed hasn’t even disclosed the criteria of the stress tests, which the banks invented themselves.

This is just another example of how the financial industry has completely captured the regulatory apparatus. If a teacher out your child passed exams in this manner, he would be expelled. The banks are exalted. And when anyone tries to make the common-sense argument that the banks committed reckless fraud that broke the financial system and nearly toppled it, they are hushed from the sidelines, with regulators and their allies in the media moaning that it’s just too hard to prosecute. Baloney.

Contrary to prevailing propaganda, there is a fairly straightforward case that could be launched against the CEOs and CFOs of pretty much every US bank with major trading operations. I’ll call them “dealer banks” or “Wall Street firms” to distinguish them from very big but largely traditional commercial banks like US Bank.

Since Sarbanes Oxley became law in 2002, Sections 302, 404, and 906 of that act have required these executives to establish and maintain adequate systems of internal control within their companies. In addition, they must regularly test such controls to see that they are adequate and report their findings to shareholders (through SEC reports on Form 10-Q and 10-K) and their independent accountants. “Knowingly” making false section 906 certifications is subject to fines of up to $1 million and imprisonment of up to ten years; “willful” violators face fines of up to $5 million and jail time of up to 20 years [...]

The premise of this requirement was to give assurance to investors as to (i) the integrity of the company’s financial reports and (ii) there were no big risks that the company was taking that it had not disclosed to investors.

This section puts those signing the certifications, which is at a minimum the CEO and the CFO, on the hook for both the adequacy of internal controls around financial reporting (to be precise) and the accuracy of reporting to public investors about them. Internal controls for a bank with major trading operations would include financial reporting and risk management.

It’s almost certain that you can’t have an adequate system of internal controls if you all of a sudden drop multi-billion dollar loss bombs on investors out of nowhere. Banks are not supposed to gamble with depositors’ and investors’ money like an out-of-luck punter at a racetrack. It’s pretty clear many of the banks who went to the wall or had to be bailed out because they were too big to fail, and I’ll toss AIG in here as well, had no idea they were betting the farm every day with the risks they were taking.

This is one of maybe dozens of cases that could be undertaken. In some cases, the SEC is actually investigating. But as long as we have a regulatory structure that literally lets the banks determine whether or not they are healthy, we’re never going to see equal justice performed.