Banks Get Stress Tests, Investors Get Stressed

Banks Get Stress Tests, Investors Get Stressed

Commentary by Caroline Baum

April 22 (Bloomberg) -- The idea wasn’t to create angst among investors. Rather, the stress tests were designed to assess the capital adequacy of the 19 biggest banks under a variety of economic scenarios during the next two years.

Somehow, in the two months since the tests were announced by Treasury Secretary Timothy Geithner, the exercise has morphed from an internal process to ensure banks can withstand additional loan defaults to a financial market fixation with a moveable end date and changing terms.

With a white paper on the stress-test methodology due for release Friday, followed by the results of the examinations on May 4, the bar has been set very high for the Federal Reserve, which is coordinating the exams. Unless investors lower their expectations, there’s bound to be disappointment over a lack of detail on the May 4 report card.

Ignore for the moment the fact that it’s against the law for any regulator to release information from a supervisory examination. (The law provides for a process whereby the heads of the various regulatory agencies can breach that confidentiality and release specific information.) If the government opts to keep the nuts and bolts secret -- “They all passed” -- or releases select, generic and no doubt upbeat information, it risks a loss of confidence among investors.

President Barack Obama and his Treasury secretary remember the thumbs-down response when Geithner unveiled the new Financial Stability Plan on Feb. 10. The veil went up, stocks went down -- 4.6 percent for the Dow Jones Industrial Average.

Earlier this week, the Treasury had to deny a blog posting claiming most of the banks were insolvent in an attempt to quell a sell-off in bank stocks.

New Testing Standards

While the Fed has been working to increase transparency, greater openness applies to the central bank’s objectives, forecasts and implementation of policy, not to its proprietary information on the bank-holding companies it regulates. That’s worth bearing in mind in advance of the May 4 report card.

The public at large already thinks the government is in bed with the banks, which it is to the tune of $200 billion via its capital purchase program. Americans will probably assume the bad news is being swept under the rug or the numbers are being fudged until the government can come up with another plan to keep the banks afloat.

Yesterday, Bloomberg News reported that regulators are broadening the scope of their stress tests to include the quality of the bank loans in addition to their expected performance under different macroeconomic scenarios, such as a 10 percent unemployment rate or continued decline in GDP growth.

Better Mouse Trap?

“It took 10 years to come up with Basel II, and the models failed,” says Josh Rosner, managing director at Graham Fisher & Co., an investment research firm in New York, referring to international standards on capital adequacy. “Is it credible that the Treasury and New York Fed could come up with an alternative stress test in two weeks?”

Like many of the decisions throughout the crisis, the tests “were supposed to be confidence inspiring,” Rosner says. Instead, the inherent conflict between the government’s desire to appear credible and its aversion to releasing bank exam data demonstrates an inability “to think about unintended consequences.”

Because it was predetermined that none of the banks would be allowed to fail, the only question is what will be required to award them a passing grade.

It’s like the third-grade teacher who, under pressure from parents, provides special tutoring to the slow students or shows leniency in grading to avoid awarding anyone an “F.”

Supervisors Supervise

Testifying to a congressional oversight panel yesterday, Geithner said the “vast majority” of U.S. banks have more than enough capital. Those among the Big 19 that don’t will have six months to raise private capital or accept funding from the Troubled Asset Relief Program.

TARP currently has about $110 billion of the $700 billion appropriated by Congress last year. Treasury expects $25 billion in repayments this year, bringing available funds to $135 billion.

The stress tests are being conducted by an array of bank regulators, including the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Deposit Insurance Corp. in addition to the Fed. In other words, the regulators are doing what they were supposedly doing all along.

Why regulators decided at this late date that underwriting standards were an important metric for capital adequacy determination is hard to understand -- and therefore subject to alternative interpretations.

Second Chance

“The second stage of the tests, of the bank-specific follow-up, is allowing banks to justify exposure to examiners once again,” Rosner says.

He suspects the initial results weren’t great, that the broadened scope of the tests will “allow banks to give their input, to appeal” their case.

So, if the 19 banks are too big to fail, and the Fed hasn’t made a determination yet on what it will disclose to the public, what should investors look for?

The grade-A banks will find a way to let the public in on their performance. The grade-C banks will be less eager to do so. Their rating could be inferred. A tip-off might be a CEO who suddenly retires to spend more time with his family.