Just How Useful Was the Bank Stress Test?

“The Financial World According to Inya” Column,
by Inya Ivkovic, MA


Back in May, the Obama administration forced 19 of the largest banks to undergo the “stress test.” Ten out of 19 failed to pass it at the time and were given six months to raise $74.6 billion in additional capital. Eighteen of the banks have raised $77.0 billion in total and only one had failed the second time around, GMAC, which was enough for the Treasury secretary to declare that the financial system in the U.S. has improved significantly since the credit and financial crisis began.

At face value, sure, it makes plenty of sense to sign off on the good news when we went down from 19 banks to only one bank still toying with the idea of bankruptcy. However, digging deeper would show that today’s economic reality is starkly different from the one six months ago. In other words, in today’s context, the banks’ stress test carries little value.

How different could the economic landscape be today versus six months ago? Apparently, quite a bit different, both on the grim and rosy sides! For example, the economic projection at the time required the banks to account for annualized unemployment of 8.9%, while U.S. unemployment currently stands at 10.2%. In contrast, the government wanted the banks to factor housing prices tumbling 22% into the stress test. The worst-case scenario, however, did not happen. Instead, real estate prices fell 5.5% in the first half of 2009 and for the past three months have even edged higher.

The whole purpose of the stress test was to boost confidence by demonstrating that banks’ balance sheets were strong enough to endure the strongest of headwinds. This is where the regulators have stepped in and determined the factors that would affect banks’ survival rate if the recession were to sink us deeper than expected. The only problem was that the recession has diverged from the projections used to conduct stress tests, rendering them basically useless.

Undoubtedly, the economic landscape has changed, some of it for the better, some of it for the worse. While conditions have improved overall from the depth of the abyss into which we had fallen at the end of last year and early into this year, difficult conditions persist and a number of banks still face problems that the so-called stress test cushions may not be able to solve. According to Christopher Whalen, managing director of Institutional Risk Analytics, “We’re already at record numbers on losses, and those numbers are rising.” Simply put, the loss rates that the stress test has envisioned are trending more on the downside than expected and, as a result, the banks still might not have enough to keep their heads above water.The one bank out of the initial 19 that six months later is still in “detention” is GMAC. This bank still cannot unravel its bad loans to car dealers and buyers and still needs about 11.5 million dollars to pull itself out of the hole. GMAC is renegotiating with the Treasury, trying to milk more billions from the rescue fund on top of an already received 12.5 billion dollars in bailout money. Well, GMAC can seek all it wants; the terms of the stress test may change for GMAC this time around and most likely not for the better.

As for the 18 alleged success stories — those that have received help from the government — they must repay the taxpayers if they want to regain their control back. Through the repayment, plus interest, credit is slowly, but surely coming back. However, it may not be enough to help out small and medium businesses get their hands on
new credit lines. In addition, some banks are still too troubled to afford the provision of credit to others and, by extension, to support the recovery. As Whalen has put it, “These are zombies and they can’t make loans. None of this is helping the real economy. The only way to improve [things] would be to push [certain banks] into bankruptcy and get rid of the bad assets that are weighing them down.”