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May 15, 2009

Bank Stress Tests - Not so Stressful?

Released last week, the long-awaited results of the “Stress Tests” conducted under the direction of the  US Treasury Secretary, Timothy Geithner,  have since been picked, prodded, lauded and criticized.  Pundits from the right, left and the center have unleashed a torrent of mixed opinions into the media and blogosphere.  With a week gone by, I thought I would table a few questions which I envisioned might strike up a lively debate:
·         Were the Stress Tests stringent enough?
·         Rather than a true test of bank health, were the Stress Tests instead a means to boost confidence in the banking system?  
·         Will the U.S. Stress Test model be emulated by other countries, especially in Western Europe?

Were the Stress Tests stringent enough?

The opinion of most industry commentators has been something ranging from “well, sort of” to an outright “No”.  Bloomberg breaks down the economic scenario used by the testers:
“Examiners used an “adverse scenario” of a 3.3 percent contraction in the economy this year, and an average unemployment rate of 8.9 percent in 2009 and 10.3 percent in 2010. Economists see a 2.5 percent drop in output this year, and unemployment rates of 8.9 percent in 2009 and 9.4 percent in 2010, according to a Bloomberg News survey.”
Though the “adverse scenario” may be stressful, it is hardly unforeseeable. The Wall Street Journal labelled the proceedings the “Not-So-Stressful Test” and handed out a B- grade to the government (not too bad for a first effort, I suppose).  Others have questioned the 4% (25 to 1) Tier-1 capital to risk-weighted assets ratio.  Wasn’t out-of-control leverage one of the major contributors to the financial meltdown?
There is also some debate among industry observers about the US Fed’s choice of “Tier 1 Common Capital” as the hurdle for the Stress Tests; while I do not want to get into the details of different Capital ratios for Banks (Ranging from Tier 1 Capital to the more realistic Tangible Common Equity - TCE), suffice it to say that Tier 1 Common Capital is probably not a widely accepted measure, apart from being a little more lenient than TCE.

Rather than a true test of bank health, were the Stress Tests instead, a means to boost confidence in the banking system?

Though most agree that the Stress Tests weren’t all that stressful, does that really matter?  Geithner appears to have made rebuilding confidence in the banking system his number one priority.  If Stress Tests were released stating that the nation’s major banks were in terrible shape, consumer and counterparty confidence may have eroded even further.  So far, the “instill confidence” strategy has worked.  The markets are in the midst of a 30% rebound off their March lows, and the TED spread ( Difference between the 3 month US Treasury rate and corresponding LIBOR, a measure of credit market stress) has dropped over 20 basis points in a week to its lowest level in nearly a year.  Capital for those banks which didn’t pass the Stress Test was made readily available by a slew of newly confident investors.  Furthermore, consumer confidence in the banks has also rebounded slightly - always a good sign!

Will the U.S. Stress Test Model be emulated by other Countries?

Many in the European Union have been openly critical of the Stress Tests.  Even so, it has been announced that EU Bank regulators will conduct their own version of stress tests by September '09.  This is a step in the right direction.  After an initial flurry of activity, most of the EU (notably the U.K.) have been relatively slow to take decisive actions to shore up their banking system.  However, with GDP expected to plunge nearly 4% and risks of deflation rising, it has become crucial for EU regulators to act and act quickly. 

I think the Stress Tests served as a good “buying time” tactic for the Obama administration to think through other aspects of regulating the US financial markets; notice the timing of the announcement on increased oversight of Derivative Contracts, coming in, just a week after the Test results. Some of my Industry acquaintances here in the US also claim that the tests have created an escape route for the “good banks” to repay their TARP investments and get back to business-as-usual (or "bonuses-as-usual"!).

I am keen to hear your views!