Will We Learn Anything From The Bank Stress Tests?

The Wall Street Journal reported today that “top federal bank regulators plan to meet early this week to discuss how to analyze the results of stress tests being conducted on the country’s 19 largest banks.” Analyzing these tests will be a key moment in the battle to save the U.S. banking system, as the tests could confirm the insolvency of several large institutions.

With that in mind, it’s worth asking just how stressful these stress tests are, and whether they’re really going to show us anything about the banks that we didn’t already know. First, here’s what the tests entail:

Regulators designed the stress tests to ensure that banks could survive — and continue lending — even if the unemployment rate were to rise above 10% and home prices to fall by an additional 25%. The tests, which were conducted largely by economists and experts using mathematical models, seek to determine whether a bank would need more capital to continue lending under such circumstances.

Considering that unemployment is currently at 8.5 percent, and Moody’s has predicted that home prices in some areas will fall by nearly 18 percent, the scenario laid out in the stress test seems pretty plausible, and not at all a worst-case scenario. There is also a “delayed time bomb” sitting in the housing market, as Alt-A (one notch above sub-prime) and Option-ARM “teaser” mortgages are poised to reset in 2009 and 2010, potentially wreaking further housing havoc.


Maybe that’s why William Black, a former senior bank regulator and S&L; prosecutor, told Tech Ticker that the stress tests are “a complete sham” that don’t go far enough:

“There is no real purpose [of the stress test] other than to fool us. To make us chumps,” Black says. Noting policymakers have long stated the problem is a lack of confidence, Black says Treasury Secretary Tim Geithner is now essentially saying: “’If we lie and they believe us, all will be well.’ It’s Orwellian.”

As Dean Baker noted, “a stress test is supposed to examine a worse case scenario, not an optimistic one. By picking overly optimistic projections, Treasury increases the likelihood that banks will pass the stress test.”

The weakness of the stress tests may be further compounded by the recent decision to relax mark to market accounting rules, which could increase opacity and uncertainty about the value of toxic assets. If the banks are able to pretend that their assets are worth more than they really are, and the stress tests don’t push the banks to prove they can be solvent in the face of further economic deterioration, then as Felix Salmon noted, we may be “rubber-stamping utterly unrealistic [bank] balance sheets.” And that would be simply punting the problem down the road, while allowing zombie banks to continue lurching around the economy.