Feature

Issue of the week: Were the stress tests tough enough?

Gauging the results of the stress tests

You have to hand it to Treasury Secretary Timothy Geithner, said Massimo Calabresi in Time. Geithner last week released the long-awaited results of the bank stress tests, which showed that 10 of the nation’s top 19 banks needed to raise $75 billion in fresh capital. The results also included the “grim news” that in a prolonged economic downturn, the biggest banks could lose almost $600 billion by the end of next year. Yet Geithner “managed to package those findings as positive,” and thanks to some deft spinning, “bolstered the confidence of the banks, Congress, the stock market, and much of the country.” So successful was this “remarkable bit of salesmanship” that after the findings were released, bank stocks rallied for three days.

The most remarkable thing about the stress tests is that many seemingly intelligent people take them seriously, said Jeff Madrick in Huffingtonpost.com. The tests “were more or less designed to yield a foreordained result.” None of the banks received a failing grade, and—wouldn’t you know it?—their total capital needs of $75 billion are comfortably less than the $110 billion remaining in the government’s Troubled Asset Relief Program. Now the administration can point to the results to avoid having to ask Congress for more bailout money. Geithner & Co. are betting that the banks can muddle through the recession, and then get back to business as usual. Let’s hope they’re right about that.

It’s even harder to put any faith in the results after the revelation that they’re the product of “intense bargaining” between regulators and the banks, said David Enrich in The Wall Street Journal. The feds gave the banks a sneak peek at the results in April, and “at least half the banks pushed back.” Wells Fargo Chairman Richard Kovacevich, for example, was livid when he learned that the feds wanted his bank to raise an additional $17.3 billion. He “publicly derided the stress tests as ‘asinine,’” and the government agreed to reduce its estimate of Wells Fargo’s capital needs to $13.7 billion. Administration officials defend the negotiations, “saying they were responsive to industry feedback while maintaining the tests’ rigor.” They’re right about the “responsive to industry” part, anyway.

Even so, the tests do provide a “template” for a new approach to regulation, said Sebastian Mallaby in The Washington Post. For years, banks and regulators have used historical data to estimate future investment losses. That approach has its limits. After all, “models based on historical patterns in real estate caused a lot of lenders to hold too little capital against the risk of mortgage default.” By contrast, the stress tests forced banks “to imagine how their portfolios would respond to future shocks.” Considering how much damage poor risk management can do, “government has a duty” to make stress tests the foundation of a new regulatory framework.

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