US Banks to Be Subjected to ‘Stress Test’ to Measure Resilience
Quipu Economic Forum :: Comments (0)
2 March 2009 :: by Denver Lessing
The Obama administration is looking at the severity of the banking crisis with a mind to settling the issue of survivability and recoverability of banks, case by case, based on facts in evidence. The first step will be to gather evidence, through a series of ’stress tests’ designed to examine what resources troubled banks have to weather oncoming storms, then plan according to the results of those tests.
A “public-private partnership” model will be used to determine how any given bank is managed under the conditions set for receiving government “rescue” funds. This model will allow the government to measure what level of resilience there is in the bank’s accounting, funding and commercial structures, in the face of hypothetical oncoming hardship, should economic conditions continue a trend not conducive to profitability.
Treasury Secretary Tim Geithner has said the stress test will entail “a more consistent, realistic and forward looking assessment about the risk on balance sheets”. Those government agencies whose jurisdiction includes the regulation of major banks will be responsible for conducting these sustained, forward-looking assessments. But it remains unclear what sort of timetable there will be for determining resilience or bailout-eligibility.
There is widespread uncertainty about what exactly the government agencies’ scrutiny would consider and what qualifications would indicate passing or failing the stress test. Signals from the Obama administration suggest the term stress test is meant to provide a more pragmatic, “fact-based” approach to evaluating the viability of financial institutions, and that there is no great mystery.
But the banks want specifics and want to be able to say they can either count on government assistance or not. But the specifics of the government analysis seem less important than the specifics of the banks’ own planning: are they or are they not healthy enough to withstand the sorts of major market swings and spending and investment slowdowns we are likely to see in coming years.
Economic scenarios used in the bank stress tests are the equivalent of jacking up the treadmill, to unmask financial weaknesses. Stress testing is widely used in the financial industry; federal regulators use it in their periodic “safety and soundness” reviews of banks, and banks run their own stress tests.
Essentially, computer models put the banks’ accounting through a series of potential future scenarios, in order to gauge what will happen, according to current planning or other alternatives, when compounded interventions occur (i.e. spiralling gain for certain market competitors, spiralling downturns, spiralling losses, the fallout from random market events).
What is unique about this process is the broad range of possible scenarios that will likely be considered, and the fact that they will look up to 2 years out, instead of the more common timeframe of 6-months for financial stress testing. In theory, the stress tests will consider a “baseline” overall economic environment and a more severe prolonged recession scenario.
The more severe scenario was considered to be a 3.3% decline for US GDP throughout 2009, but news that the Commerce Dept. now rates the last quarter of 2008 as having suffered a decline of over 6% means even more severe scenarios could be considered. MSNBC reports that the Treasury Dept. considers the following figures as representative of a more adverse environment for 2009:
3.3 percent decline in gross domestic product this year; unemployment rising to 8.9 percent this year and 10.3 percent in 2010, from the current 7.6 percent (already the highest in more than 16 years); and home prices plunging 22 percent this year and 7 percent next year.
But conditions could be worse than that, and they could be made worse by banks’ failure to restore credit and lending practices more conducive to a vibrant consumer economy. Some have suggested the banks should hand over far more detailed information than usual, so that regulators can better judge what the best plan for spending bailout money would be, for the economy broadly, and for the sake of the government’s own future accounting, but reports suggest there will not be a new expansion of data made available to regulators.
Fed Chairman Ben Bernanke has told Congress “The outcome of the stress test is not going to be fail or pass”. Bernanke said the tests will be used to determine what level of new funding the banks need in order to get money flowing, via new loans, to consumers and businesses, in order to push back against the forces of sustained recession.
As structured now, the plan would provide banks in need of additional capital up to 6 months to raise the capital from private sources, but would make certain funding options available after 6 months, in order to get the bank to a position where it could lend more freely. Those options might include government taking a much larger stake in some banks, as reportedly has happened with CitiGroup, where the government will now own up to 36% of the firm.
