Issue of the week: How stressful is the ‘stress’ test?

If nothing else, Treasury Secretary Timothy Geithner’s “stress test” for banks is aptly named, said David Weidner in Marketwatch.com. The tests, which began last week, are supposed to gauge the financial soundness of bank companies should the economy worsen even more than policy­makers now expect. Regulators run computer simulations that forecast how, say, a 12 percent unemployment rate or an additional 20 percent fall in housing prices would affect a given bank’s finances over the next two years. “If the banks fail the test, the government has hinted it will step in with more money, in exchange for ownership.” But it’s not just the banks that are being tested. Investors want to know if Geithner is willing to take the risky, difficult steps needed to restore confidence in the banking system. He’s “walking a fine line.” If the tests are too easy, Geithner will look as if he’s helping the banks disguise their true condition. “If they’re too harsh, Treasury may be forced to inject capital into banks that are already fit.”

Many investors and bank executives already assume the worst, said Colin Barr in Fortune. They “have been taking bets on which banks might fail stress tests” and have singled out Citigroup, Bank of America, and such regional banks as Atlanta’s SunTrust and Ohio’s Fifth Third as the most likely to fail. The list might not end there, said Eric Dash in The New York Times. Some market pros suspect that the tests are merely political theater cloaking Geithner’s true purpose: “creeping nationalization of the banking industry.” The tests, said banking analyst Paul Miller of Friedman Billings Ramsey, give Geithner “the mechanism he needs to take giant steps with capital infusions.”

That would make for a nice conspiracy theory if Geithner weren’t so obviously reluctant to take over the banks, said Noam Scheiber in The New Republic. Geithner believes that government ownership, even if it’s only temporary, “invariably politicizes management decisions.” Would a bank under the control of a Democratic administration feel obliged to be extra-nice to unions, for example? Geithner also worries that federal ownership would scare away the “top managerial talent” needed to nurse ailing banks back to health. “Governments are terrible managers of bad assets,” he recently remarked.

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Recent financial history says otherwise, said Joe Nocera in The New York Times. “The government did a terrific job managing banks during the savings and loan crisis of the 1980s.” It took over failed S&Ls, fired the managers who had run them into the ground, stripped out the bad assets, “and sold the newly healthy banks to private buyers.” Ultimately, the government made a profit on the S&L bailout. Seizing banks that fail the stress test would obviously be “a much more complicated and difficult proposition.” But it can be done.