Failure is the only success in stress test

Failure is the only success in stress test

Failure is the only success in stress test


The US will release some information about the methodology of the stress test of 19 major banks on Friday according to reports, with results slated for release in some form on May 4.

What is far from clear is if this will be some sort of self-deluding exam in which all of Treasury Secretary Tim Geithner’s children are judged to be above average or whether the US will take this opportunity to take real and difficult remedial action with banks that are too insolvent to play their role in the economy. Injections of equity for those which need it should be made at the common equity level — anything else at a severely undercapitalised bank just scares off other equity investors.

This is a good step for some banks, but sadly may not be enough for all, in which case the US should simply take the time-honoured route of taking the zombie bank into government conservatorship, wipe out shareholders and top management, and set the stage for a controlled dismemberment of what is left.

Unclear picture

This is preferable to simply upping government support and stakes because it is clear and limits not just the benefits to those who’ve made bad decisions in the past but also the power of the state. In the current situation, no one really has any idea how or when the US will increase, exit or manage its stakes in banks. It is all too easy for the government to become subject to special interest pressure in the current situation.

A conservatorship, along the lines of what has been done in the past for Continental Illinois, actually limits the potential for government abuse, such as politically motivated lending, even though it is a greater use of government power. Once that state admits that a bank has failed, it pretty much has to dispose of the assets, which is cleaner and easier to oversee and protect from abuse.

Voices in wilderness

And even putting aside issues of government control, capital will not flow to banks in the current situation. Geithner, appearing before Congress on Tuesday, said that the “vast majority” of banks have more capital than then need, a statement that was; very likely true, greeted with joy by equity investors, and almost entirely beside the point. It is not that most banks may fail, it’s that some very large ones quite possibly should.

Far more germane, and of more concern, was a report by the International Monetary Fund, which upped its estimate for global write-downs by banks and other financial institutions to $4.1 trillion. Assuming that US banks take their leverage ratio, in this case the relationship between tangible common equity and total assets, to 16-1 or so, as against 25-1 before the deluge, the IMF is forecasting that there is still a need for a half a trillion dollars of more capital.

“The current inability to attract private money suggests that the crisis has deepened to the point where governments need to take bolder steps and not shrink from capital injections in the form of common shares, even if it makes taking majority, or even complete, control of institutions,” the IMF said.

Straightforward decision

The IMF further said that bank earnings will only partially offset credit losses, so a policy of keeping the banks alive and allowing them to earn their way out of the hole is fraught. They forecast loan charge offs to peak at 4.2 per cent in the US, about double the worst seen in the recession of the early 1990s but thankfully below the 5 percent plus levels seen during the Depression of the 1930s. This could be a wrong analysis, but if it is not there is a disturbing chance of an extended downturn similar to Japan’s experience with its lost decade. All told, when the risks, both of what amounts to corruption and economic damage, are compared to the difficulties of seizing the worst banks, it seems a fairly straightforward decision.

Bigger issue

But of course in reality it is not, and I can’t predict what the US will do. “These ‘too big to fail’ institutions are not only too big, they are too complex and too politically influential to supervise on a sustained basis without a clear set of rules constraining their actions,” Kansas City Fed President Thomas Hoenig told Congress earlier this week.

This is quite a statement for a sitting central banker to make in the current circumstances. His point about the political influence of large institutions is well made and disturbing, and applies not just to future plans for regulation but to the current state of play. It is not just the banks which will pass or fail this test.

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