The purpose of the "Stress Tests" was (a) to work out how much (extra) money banks will need to keep going until the end of the financial crisis (b) to reassure the markets that, as Secretary Paulson declared in July 2008, "the US banking system is safe and sound."
Presumably with regard to (a) the government will have obtained the answers that it needs; this was not the case in July 2008. At that time the government had no idea how much money would be needed - that's progress.
With regard to (b) the fact that the "stress" might have been a lot less “stressful” than some people might have liked is irrelevant. Banks have always operated at the "pleasure" of government. It is up to the government to decide what level of "cover" they need to be allowed to continue operating. And if that number is zero, or if some assets were valued mark-to-market it is negative, the government is perfectly entitled to show some "forebearance".
Typically, coming out of a financial crisis many banks are technically insolvent, particularly under any sensible base-case regulatory structure. Big deal - that’s why they are called financial crises. But this is not a base-case, this is a crisis, and that's something else.
Some good can come out of this:
In July 2003, the International Valuation Standards Committee (IVSC) wrote to the Bank of International Settlements (Basel II) to say that the valuations used to assess capital adequacy (mandated at the time by most regulators and under US GAAP and IFRS), were "fundamentally flawed and bound to be misleading".
That wasn't an idle threat, IVSC was set up after the Asian Crisis to create a framework so that what had just happened then (banks going bust mainly because of exposure to real estate), didn't happen again.
Well it did happen again, on a much bigger scale, and the reason it did had nothing to do with greed or fraud, it was because the valuations (from 2003 - 2007) were "fundamentally flawed and bound to be misleading." And they were misleading, otherwise Secretary Paulson would not have said what he said. Yet the whole purpose of banking regulation is to stop this sort of thing from happening.
What IVSC were recommending, via International Valuation Standards (IVS), is basically what is happening with the "stress tests", which is to explicitly acknowledge that markets often mis-price assets, therefore the timing and purpose of a valuation must explicitly take this fact into account. This is why IVSC came up with the concept of "Market Value" and "Other than Market Value."
Hopefully the "Stress tests" or a variant of them will become part of the regulatory framework; if IVS had been in place in 2003, in 2007 every valuation would have been mandated to explicitly recognize that the housing market was mis-priced, and appropriate action would have been taken, in good time.
As far as I can see, what is happening under the “Stress Tests” is identical to what would happen if IVS was used as a basis to assess capital adequacy.
It is perhaps unfortunate that the government has decided to "make things up as they go along", because this risks losing credibility and trust.
If instead they had declared that from now on valuations to assess capital adequacy should "conform strictly to IVS" they would have looked completely clean. After all, IVSC is a United Nations NGO (immune from political pressure), and IVS are approved by every valuation institute in the world, which is more than can be said for either US GAAP or IFRS.
Adopting IVS would have had exactly the same effect as the "do-it-yourself" solution but would have obtained a better "bang-for-buck" in the (b) department.
Disclosure: No Positions
