Is It Time to Plan Another Round of Stress Tests?

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Now that the bank stress tests are completed, is it time to plan another round? The government's bank exams, the results of which were released in early May, seem to have calmed the market and paved the way for the nation's largest financial firms to raise tens of billions of dollars. As a result, a number of academics and policy watchers are warming to the idea of making the stress tests permanent. They like the fact that the stress tests have restored confidence in most of the nation's largest banks. What's more, they argue that even in good times the public bank exams make sense because they could sound the early-warning sign that was missing two years ago. A regular public vetting of the big banks' laundry might also cause some financial firms to be more cautious in the future about the types of loans they make.

"I think a souped-up version would be an interesting exercise to do on a routine basis," says John Irons, research and policy director at the liberal-leaning Economic Policy Institute think tank. "I could imagine in good times that this type of stress test could remind people not to get caught up in the irrational exuberance of bank booms." (See 25 people to blame for the financial crisis.)

Already, the IMF has recommended that European regulators follow the U.S.'s lead and run stress tests on their banks. And there are hints from the Federal Reserve that at least some aspects of the stress tests will become part of the ongoing regulatory system. Fed Chairman Ben Bernanke has said that the stress tests were "an enlightening exercise that will improve the tool kit we use to help ensure the safety and soundness not just of individual firms but of the financial system more broadly."

In good times and bad, bank regulators are supposed to be probing financial firms to see if they hold adequate capital for the loans they make. And the Federal Reserve does publish data about the banks and their capital four times a year. But unless you are a bank examiner or some other industry insider, those so-called call reports are nearly impossible to read and understand.

What was different about the recent stress tests was that unlike the usual bank-by-bank examinations, the stress tests looked at all the banks as a group. By aggregating the data, the Fed presumably could make better estimates of what would be the loan losses at the individual banks. The stress tests also looked out two years, instead of the usual one, as regulators gauged if banks could weather a worsening of the economy — where the stress in the name comes from — and not just whether they had enough capital to pay for current losses. Most importantly, the results of the stress tests were publicized and presented in a way that was easy for most people to understand. (See how Americans are spending now.)

For now, the Federal Reserve says the stress tests were a one-time thing and it has no plans to do them again. One problem with regularly repeating the tests is that they are expensive and time-consuming. The current one took 150 bank examiners six weeks to complete. Bert Ely, a bank-industry consultant, says bank executives don't want the stress tests to return. While Ely says he does believe the stress tests have influenced how regulators will view banks in the future, he's not sure he sees the point in them. "This is the government trying to steer business away from the weaker banks," says Ely.

But the biggest criticism of the stress tests has been that they were not stressful enough. For instance, the government's "adverse case" scenario assumed an unemployment rate of 10.3%. But some economists are already predicting that unemployment will reach that level — or worse — in this recession. So the government's adverse scenario seems to be the actual one we are in for.

Still proponents of doing the stress tests say there is an easy way to remedy that problem: do the tests again. As the economy worsens, you could apply more adverse economic conditions to see if the banks hold up. If the economy improves, revised stress tests might also tell you when it is time for the government to pull back the federal assistance it has lent the banks.

"You can't have banks stress-testing all the time, so there is a cost-benefit analysis to be done," says Martin Bailey, who was a chairman of the Council of Economic Advisers under President Clinton and is a senior fellow at the Brookings Institution. "But if you can make the tests efficient, then I think they should become a part of the arsenal of regulation, particularly of the larger financial institutions."

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