Get Ready for the Banks’ “Stress Test” Results

by Inya Ivkovic, MA

The Federal Reserve ran so-called “stress tests” on 19 large banks, the methodology of which is going to be released tomorrow and the results on May 4th. According to Associated Press, the Fed’s approach was to have a much harsher view on loans than on troubled assets. Such an approach was likely to favor a few Wall Street banks and to place certain regional banks in regulatory jeopardy. Everything will depend on how much capital banks have been able to hold on to that can help them survive if the recession gets any worse, which is a likely scenario, at least in the short term.

Such specific focus by the Fed on more individualized loans and not so much on securitized loans that Wall Street engages in could result in serious trouble for large regional banks. Analysts argue that such an approach is all about damage control, minimizing losses and classifying what can be written off as collateral damage and what cannot.

In other words, if a large regional bank were to fail, it would present a severe financial risk for the region and the country’s banking system. But if a bank dealing with securities were to fail, due to being so intricately interconnected to all corners of the world, its failure would threaten to collapse the entire global financial system. So, I suppose that could also be called prioritizing or choosing between a rock and a hard place.

Under one scenario, which should be clarified tomorrow, observers hypothesize that the test assumes banks engaging in securitized loans have already lost what was there to lose and if the credit crisis gets any worse, for Wall Street banks, the worst has already happened. In contrast, regional banks’ individual loans still have “room” for losses. According to some estimates, those losses could even hit the 20% mark.

And here’s the rub: this “methodology,” while reasonable at face value, appears to penalize the banks that have stayed away from troubled assets and engaged only in traditional lending, the kind that American consumers need and the kind that financial and credit markets need so that the credit crisis could unwind itself.

To add insult to injury, according to the American Bankers Association, major regional banks have been performing much better than Wall Street banks in recent months. In aggregate, regional banks’ portfolios have taken a hit of only about five percent, while complex securitized portfolios have lost between 30% and 40% since the credit crisis struck full force last year. Yet, the former group could be the one failing the Fed’s stress test.

I suppose we’ll find out on May 4th. Incidentally, both the Fed and Treasury refused to comment on the stress test methodology as of yet. But in less than a fortnight, 19 financial institutions with assets of $100 billion at a minimum will have been put through quite a ringer and some will potentially be penalized for a situation they didn’t directly contribute to. I just thought PROFIT CONFIDENTIAL readers would like to have the full picture before hailing or condemning the results of 19 stress-tested financial institutions.