The big news on the banking front this week will be the public release of the stress test results, currently scheduled for Thursday (originally it was supposed to be today). Over at The Hearing, I wrote an overview post recapping the context for the stress tests and the current dilemma the administration faces: whether to keep quiet about the details, and risk undermining the credibility of the exercise, or whether to release signficant bank-specific information, and risk undermining the reputation of certain weak banks.
There is nothing wrong with the concept of the stress tests, and arguably regulators should have been doing them constantly as the crisis worsened, so that this particular iteration would not create such a political challenge. The idea is that not only do you want to know how much capital a bank has right now, but you want to know how much capital it will have left if the economy continues to get worse. If you did this analysis in a way that was credible with the market, it would go a long way toward restoring confidence in the financial system, since the current lack of confidence is based on people’s not trusting the information they are getting.
However, right now the stress tests face a number of risks:
- They have partially undermined themselves by using a “more adverse” scenario that is roughly in line with what most forecasters think is actually going to happen, so they are not very stressful.
- The administration has already as much as said that the banking system is well capitalized and no banks are going to fail, which makes it seem like the results are preordained.
- There is a widespread expectation, fostered by the administration, that any capital deficiencies will be plugged by converting preferred to common stock in an attempt to boost tangible common equity, rather than providing real cash money to banks.
- Most importantly, the announcement of the results was delayed so that the administration could negotiate with Citigroup and Bank of America over their report cards, which does not exactly foster confidence in the results that will eventually be announced. The term “stress test” was borrowed from medicine; do patients negotiate with their doctors over their diagnoses?
While this may have started out as a technical, regulatory exercise, it has become an exercise in political communication. The goal is to be harsh enough on a few specific banks to maintain confidence in the stress tests, but be nice enough so as not to undermine confidence in the entire financial system. That’s ultimately what this is about.