Saturday, April 18, 2009

Jobless put new slant on stress tests

Posted on the Financial Times by Krishna Guha:

Rising unemployment is prompting US authorities to consider taking a tougher stance in judging the results of bank stress tests, a development that ultimately could force leading financial groups to hold more capital.

The stress test process is intended to ensure that the big US banks have enough equity capital to comfortably survive a recession that is worse than officials presently expect – a so-called “adverse scenario”.

When the stress tests were revealed two months ago, the authorities defined the adverse scenario as one in which unemployment rose gradually to peak at 10.4 per cent in late 2010.

But, since the announcement was made, unemployment has risen much more quickly than was expected, even under the “adverse scenario”. The Federal Reserve and a number of other economic forecasters also revised down their estimates for growth over the next two years.

The upshot is that the likelihood of unemployment reaching 10.4 per cent looks higher than it did at the onset of the exercise.

The authorities believe it is too late to revisit the assumptions underpinning the stress tests. However, it is not too late for them to decide to interpret the implications for capital more stringently. The Treasury declined to comment.

Making such an adjustment would help arguments against claims by critics such as Nouriel Roubini, chairman of RGE Monitor, who wrote on his blog: “The stress test results are meaningless as actual data are already running worse than the worst case scenario.”

The authorities have not yet made a final decision on changing the way the tests will be interpreted. Even if officials do lean in this direction, it may never be visible because they did not specify in advance any precise formula relating stress test outcomes to required bank capital. Moreover, signs of economic recovery could persuade policymakers to disregard the rapid recent rise in unemployment on the grounds that it might revert to the less alarming trajectory they originally expected.

Policymakers also believe that other assumptions in the test still reflect a worse-than-expected outcome. Nonetheless, unemployment is an important driver of loan defaults.

At the same time, administration officials are pressing wary banks and regulators to agree to disclose summary details of the stress test assessment of each bank’s assets. They believe that this information would help markets evaluate the financial health of each bank as well as reinforce the credibility of the stress test exercise. They do not think that even weaker banks could benefit from hiding the results from the market since investors would probably fear the worst.

However, they want to avoid a disorderly situation in which the stronger banks advertise the results of their stress tests while weaker banks resist doing so. This could further stigmatise the weaker banks and lead to an additional loss of confidence.

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