More European Stress-Test Nuttiness

| About: iShares MSCI (EUFN)

I was on Bloomberg TV Wednesday morning and the host, Betty Liu, wanted to know what I think about this new round of stress tests the government has in store for the banks. I told her that they’re a really dumb idea. But TV news being the fast-paced enterprise it is, I didn’t have an opportunity to engage in an extended rant as to why.

So allow me to elaborate now. These annual stress tests for the banks are an incredibly stupid, truly nonsensical practice. They are the sort of crazy scheme that Congress sometimes hatches which makes so many of us wonder whether the people we send to Wasghington really are idiots.

Go back to banking basics, and I’ll explain what I mean. The reason banks carry capital on their balance sheets in the first place, over and above the loss reserves they book when they write loans, is so they can navigate through and survive periods of unexpected losses. One might even think of those periods of unexpected “stress.” Related to that, banking regulators specify the minimum amount of capital that banks must carry to see them through such periods of . . . um . . . stress. If regulators don’t think the minimum standards they’ve set are sufficient for banks to see them through those times of . . . stress . . . they can and should raise the standards. The whole point of minimum capital standards, after all, is to ensure that banks survive unexpected periods of stress.

You see where I’m headed with this, don’t you? If the country’s banking regulators don’t believe that the minimum capital standards they themselves have promulgated aren’t sufficient to get the banking industry through a storm, they should raise the darn standards! It’s easy! No act of Congress needed. No environmental review. Just send a memo out to the banks and tell ‘em that to be considered “well-capitalized” they now need to maintain a Tier 1 ratio of 10%, or 12%, or whatever—just pick a number!

But if these same regulators are required (which they are, by this marvelous Dodd-Frank Act) to run annual stress tests on the banks to ensure that banks’ finances really are strong enough to get banks through tough times, then their own minimum capital standards are meaningless. How can that make sense? It doesn’t—but the regulators don’t care. They love the new stress tests since the tests will help them cover their own keisters when things go bad.

If the government believes the world has changed, and that future credit downturns are apt to be more severe than past ones, that would be totally rational. Even prudent. But the response should not be to layer in a new round of annual stress tests for the banks, it’s to dial up the minimum amount of capital cushion that banks have to hold. Duh. This shouldn’t be complicated. Even for the people who work in government.