The Stress Test Stress: Making a Bad Situation Worse

 |  Includes: KBE, XLF
by: Vernon Hill

If you were going to concoct a process for regulating the banking system that would be certain to take a bad situation and make it even worse, how would you go about it?

First, you might devise a top-down, overly broad “stress test” for the banks that, because it didn’t take account of each institution’s individual characteristics such as its location, asset mix, and underwriting history, would be virtually sure to spit out meaningless results.

Second, you’d announce that —in contradiction of decades of regulatory practice—you’d actually announce the results of the bogus tests.

Then once you realized the havoc publication of the results might cause among depositors, you’d backtrack and say that, no, you wouldn’t publish the results.

Then you’d react to the inevitable allegations of “coverup” by saying, that, yes, you would release the some of results after all.

Perfect! Here’s the situation you’ve set up: If you publish results that show that most banks passed the test with flying colors (except for, say, one or two that were already suspect), investors and depositors will assume the system is rigged, and discount the results. The public now has less confidence in the banking system than ever.

Alternatively, if you publish results that show that a number of institutions previously thought to be healthy are in fact stressed, you’ll risk inducing runs on those institutions, which in turn will weaken the system further, not to mention the federal insurance fund that’s supposed to support it. Public confidence in the system will in turn fall. The public will then, inevitably, assume the stress conditions you input into the tests in the first place weren’t severe enough, will discount the test results entirely, and will begin to doubt the solvency even of the institutions that your test has certified to be healthy.

Well done! You’ve designed a process out of which can come no good outcomes. And you’ve done it at a time when the banking system was at last showing signs of renewed strength on its own.

Click to enlarge