The US banking stress tests are set to begin today. We’re still awaiting details but here’s what we know so far.
The tests are part of US Treasury Sec Tim Geithner’s financial stability program and involve assessing the ability of America’s biggest banks to withstand “stress” (duh) — or various economic scenarios. Fed chairman Ben Bernanke gave a few hints on the structure of the tests in his testimony to Congress yesterday — saying they’ll be looking at potential losses on loans over two years rather than the normal one year. Here’s another snippet from the New York Times:
The stress tests will use computer-run “what if” situations to estimate what would happen to each bank under Depression-like conditions, with unemployment surging to 10 or 12 percent, for example, or home prices dropping 20 percent further, Treasury and Federal Reserve officials said. Fed officials emphasized that these hypothetical events were “highly unlikely” to occur.
You can debate whether such stress tests are even feasible, as the “Keating Five” whistleblower William Black has already done. However, for today, let’s focus on two points: the stress in the stress test and the potential results.
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Economist Paul Krugman points out that in fact “quite a few forecasters” expect unemployment to top 9 per cent — making 10 per cent-plus a real possibility. Moreover, looking at US housing data he notes that the price-rent ratio is still 15 per cent above its 2000 level, making a 20 per cent drop (a 5 per cent overshoot) entirely plausible. He says:
Bottom line: that “highly unlikely” case seems all too possible to me. Maybe not the most probably outcome, but hardly a black swan.
That’s one example, but it will inevitably be the case that forecasters disagree on future economic conditions. Doing an effective stress test effectively means forecasting future “stress” in the economy — and that’s something economists, bankers and government officials are still clearly divided on. But not making the stress tests ‘stressful’ enough clearly negates the purpose of such a massive undertaking, while making them too onerous will subject the banks to unnecessary pain.
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Yves Smith at Naked Capitalism makes an even more acrimonious point, when she asks whether the stress test results are predetermined.
She quotes one unnamed government official:
“I think the market is missing that the whole intent of this process is to show that the banks have enough capital for even worse outcomes than we currently envision and to show there’s a program in place to give banks access to that capital if they need it.”
That could easily be a slip of the tongue of course, but it could also be indicative of the US government’s general attitude. Perhaps this is just a mass exercise to reassure the public/Wall Street — the banking equivalent of Keynes’ digging holes to counter unemployment; it doesn’t really achieve anything but it does keep people — and markets — busy.
In any case, if the US were to decide that banks need additional capital there’s still a raging debate as to what form that capital should take (discussed at length here and here and here and here) — more preference shares or common stock?
All in all, at the moment, the stress tests are ironically yielding more questions — and stress – than answers.
Related links:
Stress tests for banks exposes rift on Wall Street - NYT
Stress tests to map future for ailing banks – FT
Stress tests, debunked – FT Alphaville
How stressed are you?