Monday, April 20, 2009

Stress test charade?

The NYT reports that after labouring through records of nineteen of the largest banks for the past eight weeks in the name of "stress tests" under the Geithner Plan, nearly 200 federal examiners appear to have come to an interesting conclusion - the banks are in a better shape than what everyone thinks, but despite all the bailout money pumped in, they will still need further bailing out! This raises the question - if all the banks have passed the stress tests, but will still need to be bailed out, then what was the purpose of these tests?

The tests, led by the Federal Reserve, rely on a series of computer-generated "what-if" projections in the event the economy deteriorates, so as to judge all the financial institutions against a common set of standards. Those include unemployment rising to 10.3% by next year, home prices falling an additional 22% this year, and the economy contracting by 3.3% this year and staying flat in 2010. Critics have questioned these standards as all being too optimistic. As part of the tests, the banks analyzed each category of loans they held and compared their results with the "high" and "low" range of government loss estimates. The banks were also asked to project their earnings over the next two years to give the regulators a better sense of how much capital they would have to absorb the coming losses.

Since the tests are being conducted outside public view with little or no disclosure, there are serious dounts being expressed about the rigour of these tests. The credibility of stress tests will be open to question if all those exposed to it pass the test. The Geithner Plan had hoped that the stress tests would provide a "seal of good book-keeping" to bridge the information asymmetry and encourage investors to lend to stronger banks, thereby enabling them to raise capital for their regular activities and in the process unfreeze the deadlocked credit markets.

Naked Capitalism has this scathing indictment of the stress tests, describing them as a "charade" and a "complete sham". In the absence of transparency about the stress test details and the controversy surrounding the use of tangible common equity as the measure of capital adequacy ratio, some others have called the TARP stress tests asinine.

The Geithner Treaury will argue that these tests give the government adequate information to assess the extent of problems and formulate specific bailout plans for each institution, instead throwing money into dark holes, as was hitherto being done.

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