BLOG VIEW: Four Questions About Those Bank Stress Tests

Written by Jessica Lillian
on April 16, 2009 No Comments
Categories : Blog View

a speech delivered this week to college students and faculty, Federal Reserve Chairman Ben Bernanke sought to answer the four big questions [/b]about the financial crisis. Bernanke's quad Q&A approach, he noted, was ‘in the spirit’ of the Passover ritual involving a set of four questions traditionally posed by young children at the holiday meal. Although this year's Passover holiday is now drawing to a close, asking the big questions – especially in regard to serious current events that will affect us all – should be a year-round ritual, and one that is never limited to inquisitive children. Thus, I've adopted Bernanke's festive four-question format here to ponder an important recent development in our ongoing financial crisis. Here are four pressing inquiries on the government-ordered stress tests for the biggest banks in the country, and recent reports now surfacing that state the Obama administration plans to release the results of these tests. [i]1. Can a bank actually fail these tests?[/i] The notion of a stress test conjures up images of a bank (or sedentary bank executives, perhaps) trudging away on a humming treadmill, strapped to sensors and stationed next to a doctor or trainer scribbling results on a clipboard. The tension rises as we wonder whether the subject will pass or failâ�¦ These stress tests, however, appear to involve neither cardiac challenges nor an actual possibility of failure. General expectations, as expressed by both government officials in televised interviews and numerous published reports, are that all 19 major banks subjected to the hypothetical financial-stress conditions will ‘pass.’ [i] 2. Could test results serve as justification for further bailing out?[/i] Of course, even though failure will not be an option, for some of the institutions, surviving the economic conditions used in the stress tests' financial modeling might require additional capital. According to government officials quoted in [u][link= http://www.nytimes.com/2009/04/15/business/economy/15bailout.html?_r=2&hpw]a recent New York Times article[/link][/u], fresh cash infusions for stressed banks would be provided by either private investors or – if the bank cannot raise private capital within six months – taxpayer funds from the Treasury. In other words, all the banks will endure their treadmill runs; we all just might need to hold their hands when the heart monitor reaches its danger zone. [i]3. To what degree will the ‘official’ results of the tests, as reported by the government, reflect reality? [/i] Similarly, is the administration's decision to reveal at least some information on stress test results an effort to provide transparency, or simply political-psychological trickery? Prevailing public sentiment leans toward the latter. ‘Only time will tell whether the banks sink or swim. [In the] meantime, having something to report about the health of the banks is a political issue, not an economic one, in my opinion,’ writes one commenter in response to a recent Wall Street Journal article on the subject. The selectivity of the information released – and likely filters through which it will be processed before it reaches public eyes – further provoke suspicion. ‘Those banks can all see our credit scores at will,’ points out another reader. ‘Now they don't want us to see theirs.’ Obviously, releasing any information indicating alarming weakness in a financial institution would not be conducive to inspiring confidence in our banking system – an unquestionably essential ingredient for a broad financial recovery. Therefore, unveiling stress test results, the Obama administration must simultaneously assuage fears, give an impression of sufficient transparency and provide actual, useful data. Is that tough trio even possible, especially as surrounding announcements – such as banks' own proclamations on their results – will create competing noise? As the NYT article points out, ‘Indicating which banks are most vulnerable still runs some risk of doing what officials hope to avoid.’ [i]4. Is the current economic reality already worse than the worst-case scenario built into the tests? [/i] According to a white paper from the Treasury Department, the stress tests incorporated two varying economic scenarios used to estimate expected losses over the next two years. ‘The 'baseline' economic scenario represents a consensus outlook and is based on the most recent forecasts available from professional forecasters,’ the white paper explains. ‘In particular, the baseline assumptions for real GDP growth and the unemployment rate for 2009 and 2010 are assumed to be equal to the average of the projections published in February by Consensus Forecasts, the Blue Chip survey and the Survey of Professional Forecasters. ‘The alternative 'more adverse' scenario for the path of the U.S. economy, by design, reflects a deeper and longer recession than in the consensus baseline,’ the paper continues. Further eroding the trustworthiness of these unfailable stress tests, some recent reports have indicated that the stresses of our current economic situation may have already eclipsed those presented in the stress tests. ‘The macro data for the first quarter on the three variables used in the stress tests – growth rate, unemployment rate and home-price depreciation – are already worse than those in the FDIC baseline scenario for 2009,’ writes Nouriel Roubini [u][link=http://www.forbes.com/2009/04/15/gdp-stress-tests-unemployment-banks-home-prices-opinions-columnists-nouriel-roubini.html]at Forbes.com[/link][/u]. ‘They are, in fact, even worse than those for the stressed scenario for 2009.’ We've used up our four questions, but this possibility raises several others: Does this reality-test situation discrepancy mean that if a bank is still standing now, it should be considered to be in good shape? Was the real world, effectively, an inadvertent stress test? Or should the tests be run again, with some brand-new variables? [b]- Jessica Lillian[/b], [i]Commercial Mortgage Insight[/i

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