Bank Stress Tests: Diagnosis or Distraction?

I wrote on March 19, 2009 (MLToday, Dr. Doom and the Temple of Economic Pain):

The "stress tests" that will be applied to financial institutions to assess their health will reveal much of the clandestine assets – both real and toxic – to government policy makers and allow them to better craft effective solutions, but these policy makers also fear that this information itself would be toxic to capitalism's tarnished image. Public knowledge of these "assets" would likely expose the corporations for the insolvent creatures they are. Thus, the TCE ratios will magically make the insolvent appear salvageable.

I was wrong – dead wrong. I noted then that the stress tests were going to engage an arcane evaluation scheme – TCE ratios – that would inflate the capital/assets levels to make the 19 stress-tested banks appear healthy. Instead, the Federal Reserves took a further step and used an equally arcane, and more liberal, calculation - Tier 1 Common Capital ratio – that painted an even healthier picture for the 19 stress tested banks.

As reported in the May 9-10, 2009 Wall Street Journal, the Tier 1 methodology jacked up the available capital/asset ratios on 15 0f the 19 banks. For example, Bank of America has a TCE ratio of only 2.9%, but a much stronger Tier 1 ratio of 4.6%; JP Morgan Chase has a TCE of 4%, but scores 6.5% on the Tier 1 calculation; and Bank of NY Mellon reads 3.8% TCE, but a whopping 9.5% on a Tier 1 calculation.

What is important here is not the content of the various testing methods – details that interest only a handful of academic economists – but the Federal Reserves determination to paint a rosy picture of bank health. Of course the stock markets and pundits reacted to this rosier picture with jubilation.

But if sleight-of-hand were not enough, the Federal Reserve delayed the results of their “findings” to allow the banks to lobby for an even more favorable evaluation. In the case of Citigroup, the Feds initially estimated a capital shortfall of around $35 billion, but after some jawboning, the Fed released a much lower estimate: $5.5 billion. In a bitter public feud with the Federal Reserve, Wells Fargo succeeded in having its capital deficit estimate reduced from $17.3 billion to $13.7 billion.

Imagine a high school teacher that ex post facto liberalized the grading system and welcomed student negotiation. No doubt such a teacher would be popular with students, but an unreliable guide to student performance. Similarly, the Federal Reserve’s stress tests are acceptable to the banks (and Wall Street), but useless as a gauge of the top banks actual viability. The stress tests are quite simply politically motivated theatre.

These results show the enormous leverage the financial sector exercises over government policy makers and regulators. There is no reason to believe that there is any will or determination to rein in the Cowboy Capitalism that spawned the current deep crisis. Political considerations shaped the results well before the results were in. The Obama economic team was determined to pose the banking system as healthy as a hedge against both anti-bailout sentiment and more radical options like nationalization. Of course most of the media encouraged this posture.

We know no more about the health of the US banking system than we did a month ago.

Zoltan Zigedy