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The · Psychohistorian


Stress test foolishness

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You may have heard of the banking industry "stress tests" - "what if" scenarios to see how the government thinks banks would fare under a variety of economic scenarios. The most stressful case is an assumption that the current recession gets even worse, deepening and continuing past the end of the year.

The result is government pressure for banks to increase their equity ratio significantly beyond what is required by regulations. This would allow them to survive in the face of losses for a longer period of time.

There is a certain amount of criticism of the government's models. For example, they say Wells Fargo and Bank of America need more capital, even though those two banks are making money despite the recession and thus wouldn't ever go bankrupt no matter how long the recession lasted. Meanwhile, they rate Capital One as safe even though it is losing money and could eventually go bankrupt if things don't get better.

There's also the issue that converting, say, the government's preferred stock to common stock, in many cases at fire sale prices, would improve banks' stress test ratings even though it would improve their ability to survive a deepened downturn little, if at all.

However, the most important issue is this: requiring the banks to be able to survive a much deeper recession might well help bring such a deeper recession on. To see this, let's look at the two basic ways to improve a bank's stress test rating:

1. The bank can raise capital by issuing more stock, putting downward pressure on the stock market. With the stock market recovering, people have started to spend money again, but a reversal of that recovery could make the restaurants empty again.

2. Reduce debt by reducing loans and discouraging deposits. Fewer loans of course will limit economic recovery - the restaurants may be full, but they may not be able to manage their cash to make payroll - and suddenly having lots of banking fees appear on checking and savings accounts won't help either.

Either way, it seems the government's analysis of a "worst case" recession could become something of a self fulfilling prophecy. We're currently set to come out of the recession this summer, but the government's preparing for it to continue through next winter may cause just that to happen.

Articles, one listing the results, the others discussing them:
http://www.bizjournals.com/birmingham/stories/2009/05/04/daily44.html
http://www.washingtonpost.com/wp-dyn/content/article/2009/05/07/AR2009050704257.html
http://online.wsj.com/article/SB124172137962697121.html
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