Geithner's Proposed Bank 'Stress Test' Is A Really Bad Idea

by: Tom Brown

I’ve already mentioned I’m not too crazy about the Treasury’s new plan to bolster the banking system. One part of the plan that concerns me in particular, however: the “stress test” that banks with more than $100 billion in assets will be subject to, and perhaps all banks will be subject to sometime thereafter.

Details aren’t yet available, of course, so maybe I’m just dreaming up things to worry about. But I suspect that Geithner’s cussed Risk-o-Meter will be so broad and high-level that one of its unintended results will be to force banks to add expensive capital and significantly dilute their shareholders, for no good reason.

Here’s the problem. A stress test like the one Tim Geithner described on Tuesday will almost certainly include an estimate of a given bank’s cumulative future loan losses. The likeliest way a cookie-cutter test like this would work would be to take each loan category (credit card, mortgage, commercial and industrial, and so on) and assign an expected cumulative loss percentage to each. The analysts at Barclays just went through this very exercise, in fact.

There’s a big problem with this type of analysis, though: It doesn’t adjust for the individual, historical performance of a given bank, its individual underwriting, or the geographic location of the loans.

Let’s take an extreme example of home equity loans, and you’ll see what I mean. Take two banks, Bank of America (NYSE:BAC) and Zions (NASDAQ:ZION). In the Barclays model I mentioned, the analysts assumed both banks will experience a 34% cumulative loss in their home equity portfolios.

But if you look at the actual data, that’s crazy. According to regulatory filings (which provide proper loan classification), in the third quarter, BofA’s loss rate for home equity loans was 2.5%, and its 30-to-90-day delinquency rate was 1.7%. But at Zions, the loss rate was 0.1%, while its 30-to-90-day delinquencies were 0.2%.

So there are huge historical differences between the banks. Why would any rational analysis of future expected losses at these two companies not take them into account? There are two reasons: expediency and so-called consistency. But in the rush to come up with a number quickly, the output becomes garbage. This is what Barclays did — so why not the Treasury, too?

Unfortunately, it will be garbage that’s essentially accompanied by the force of law. Presto! Certain banks will be forced to raise significant amounts of unneeded capital, solely because of the idiosyncracies of the crazy Geithner Risk-o-Meter. This will do nothing to help the safety and soundness of the banking industry. Nor, I should add, will it help attract new private capital into the industry. It is a bad, bad idea.

P.S.: An added, not insignificant drawback to the stress test idea is that it will likely distort the flow of credit. In particular, credit will tend to pile into assets that tend to have loss rates similar to the stress test’s bogeys (thereby cutting the profitability of those assets) and away from areas that have loss rates that are higher (which would cut off financing to certain parts of the economy that might desperately need it). So bank profitability and credit availability both fall. This can’t possibly be what the people at Treasury have in mind. Please, Mr. Geithner, give this one some more thought.