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There is something sad and wrong about the Fed trying to discover which are the real "banks in black."

Aren't markets supposed to determine if operating banks are safe? If the Fed needs to usurp this role isn't it a sign that markets cannot police themselves and isn't that a really dangerous situation? Shouldn't the market be subjecting banks to its own brand of stress tests? But, instead, the Fed wants to impose some other idea of synthetic-solvency and see if bankers can go through what amounts to an obstacle course especially designed by the Fed. And after seeing the results we are supposed to "feel good" about the banks. This is wrong on several levels.

The first "wrong" is that it is consumers, not the banks that are under real stress. Banks won't lend to consumers while banks themselves are overly stuffed full of reserves from the Fed and earning interest on excess reserves. Conversely, many borrowers are stuck with high-rate mortgages that cannot be re-financed but that banks are funding for peanuts. Bankers and banker surveys may tell you something different, but it is clear that people either can't or won't borrow - not that they don't want to - because bank credit requirements are too extreme. Home affordability is near or at record high levels yet home buying is anemic. And while the housing market has its own challenges there are still a lot people willing to buy homes but who are shut out or turned off by the overly stringent requirements of such high credit scores to get the best rates. Over 30% of the existing homes purchased are for cash, and it's been that way for over one year. I call this a Republican monetary policy and that's odd with a Democrat president. But only those with excess cash, high credit scores, jobs and not under water on their mortgages can refi or sell and buy houses. How does that help and what does a stress test do to fix it? Since the stress test proposes another 20% drop in house prices I guess the Fed does not want the banks to lend to support housing. Bankers wanting to pass the stress test need to lend less to housing - not more. Stress-testing banks won't help the housing sector. It might make things worse.

Stress testing is wrong because it is not a real test. The Fed can set GDP and unemployment parameters and let models track down on them but in a real crisis unpredictable stuff happens that is, well unpredictable so you can't simulate it. Models, economic models and pricing models, go off track. There is contagion. There is fear. These are not part of the Fed's antiseptic run-through. The difference between a stress test and the real thing is like the difference between Marquess of Queensberry boxing and extreme fighting. I'm guessing the Fed thinks it has its bases covered by taking such an extreme set of assumptions as its stress-test baseline. But that is wishful thinking.

Here's more my idea of a stress test and still only part of what needs to be done: take the Fed parameters and re-track the models, not at their 'expected values' but in the tails of their distributions to see what happens when things go bad AND go off track. Now that's a test.

Stress tests are idiosyncratic. Europe's bank stress tests were so good that after everyone passed the first test all the Irish banks failed. After the second round, Dexia failed. After that, the ECB pumped vast pools of LTRO funds into banks to get them to recycle them to sovereigns so that they would not have a debt crisis and imperil the banks. Europe now has a hybrid bank-sovereign debt crisis that is thoroughly intermixed. In the end it's clear that central banks impose tests on their minions in such a way that they can get all their banks through in one piece while making it sound like a horrific scenario to those on the outside. In real a crisis you do not get the repeated 'big wink' from your regulator.

Stress tests are counterproductive because they ingrain in banks the fear of risk and all but deprive them of the notion of reward. Remember risk/reward? Few bankers do. They live in a world of fee/reward and risk avoidance, or of pretend-avoidance. Pretend avoidance is where the real problems have lurked.

Stress tests also inculcate a culture of risk avoidance and of pessimism. We do not want banks to be pessimistic and we want them to confront risk, not with avoidance but with proper assessments. For all of the economic recovery, from the very first quarter of it, all we have heard of is that there is a risk of a "double dip." All that talk has been wasted. It has created angst that has held back recovery and impeded risk-takers. When are we going to have some confidence? Who will inculcate us with a culture of confidence? "Not I," said the little red hen. "Not I," said the stress-testing Fed. Hey instead let's forecast exceptionally low interest rates and weak growth all the way thorough 2014! How about that?

I wonder what - if any - contagion and losses were assumed or projected for European banks as the U.S. experienced this disaster scenario? Did EMU help its banks in the scenario? What assistance did the Fed render? Heck I wonder what European banks would do and what European GDP would do if the U.S. actually had the sort of disaster stress situation that the Fed assumed in its U.S. scenario? You know that was not well-represented by knock-on effects transmitted to banks abroad.

I do think we have had enough warnings and doomsday scenarios to last a long time. There is no better way to hold back the economy than to continually warn banks that the end may be near and they must prepare for it.

If we have a great crisis it is the central bank's job to step in. We need not prepare banks to withstand on their own "the worst of the worst." I wonder, who will stress-test the Fed's likely response? Oh the Fed, itself? Self regulation? Then we have come full circle. Remember, it was self-regulation at the SEC and elsewhere that got us here. So now, welcome to Fed-Land; right next to Chevy Chases' Wally World.

Source: The Best Of The Best Of The Stressed