Mark Thoma has a great analogy for the stress tests. He picks up on this statement by Tim Geithner:

Some might argue that this testing was overly punitive, while others might claim it could understate the potential need for additional capital. The test designed by the Federal Reserve and the supervisors sought to strike the right balance.

Then this is Thoma:

I’ve given a lot of tests over the years, and I can pretty much make the mean on a test come out how I want through the design of the questions and how I score the answers. If I want a mean of 70, or around there, I can get it, and if a mean of 50 is the target, that’s possible too. . . .

If we choose a score of “70″ as the dividing point between being solvent and being insolvent, then the percentage of banks passing the test is a function of the difficulty of the stress test: how the items on the balance sheets – the answers to the questions – are interpreted.

The whole thing is a fun read. I don’t think it’s a crucial point, but I like this part of the analogy:

Why did the government negotiate the outcome with banks and how lenient were they in those negotiations? There are always students who want to argue about the result of a test, to have sections regraded, and how you respond to attempts to “negotiate” a grade can affect the percentage passing the class, particularly when – as with the stress tests – there aren’t a lot of students/banks taking the test.

By James Kwak

### 6 Responses to Grading on a Curve

1. Blankfiend

Speaking of curves… How about parabolic Treasury yield spikes?

What happens to home prices and mortgage losses when Treasury yields ramp? How much house are people going to be able to afford with a >10% interest rate? What happens to the ARM resets? Who is going to stay in their 500K submarine of a home when the neighbor just moved in for 150K?

Were higher government borrowing rates and consequent higher mortgage rates part of the “stress” scenario?

The ongoing TNX ramp may be a more important and immediate danger to bank solvency than unemployment rates

2. DesolationRow

Hopefully Geithner’s office is far from Arne Duncan’s. Saying you won’t allow anyone to fail not only doesn’t motivate good behavior in the future but seemingly kicks a real and present problem down the road. Does the administration have any leverage for reform at this point? Whoever it was that said we need to start framing the discussion for the 2010 and 2012 elections was spot on.

3. According to the WSJ, the stress test wanted banks to have a 25-1 common equity to Tier 1 assets leverage ratio. A 25-1 tier 1 common equity ratio in some sense understates the risk regulators are signing off on. Tier 1 assets are less than book assets. This means that the Fed thinks it is alright for mega banks 30-1, 35-1, or 40-1 leverage ratio based on book assets. If one looks at market prices or the stress test results, Goldman Sachs seems to be one of the healthiest of the top TARP recipients. Nevertheless, from my calculations on pages 20 to 21 of “The Goldman Sachs Warrants” at http://ssrn.com/abstract=1400995, Goldman Sachs assets had a 5 percent standard deviation from January 1, 2008 to May 1, 2009. (On May 1, 2009, GS had a 15-1 leverage ratio of book assets over the market value of common equity.) At more leveraged banks, a 5 percent standard deviation of assets means that there is a substantial likelihood that their assets will be worth less than their liabilities. It is too bad that the Fed also believes judging from its actions with regard to Bear Stearns and AIG that taxpayers should be on the hook if these banks turn out to be insolvent and in need of emergency help.

4. Rita

Banks negotiating with their regulators regarding negative results of exams and the actions to be taken is anything but unusual. (This probably holds true for other regulated institutions like drug companies and telecommunications.) Sometimes the bank prevails and sometimes it doesn’t. We hope that the regulators (and the Obama Administration) were professional in their assessments and fair in their negotiations.

5. q

when it comes down to it, i think what the stress tests show more or less accurately is the level of losses that the US banking system can withstand at current levels of capitalization.