US banking stress tests continue to draw flak

ANALYSIS:The big banks' need for funds was lower than predicted, but many feel tests were too lenient, writes PROINSIAS O'MAHONY.

INVESTORS BREATHED a sigh of relief after the results of the stress tests of America's 19 biggest banks were released on Thursday evening, with US indices yesterday hitting their highest point since last January.

Despite this, the tests continue to draw flak from critics who insist that all is far from rosy on the banking front.

The tests found that nine of the aforementioned banking titans would not need to raise additional capital, while just $74.6 billion (€54.7 billion) was required by the remaining 10 banks. S&P analysts had estimated a figure of $120 billion. Treasury Secretary Tim Geithner said that "some might argue that this testing was overly punitive" while others might find the process to be too lenient, but overall, the tests had struck "the right balance".

It's hard to find anyone who argued that the testing was "overly punitive", however. Banks were tested as to how they would cope under economic conditions as currently forecast, as well as under a more "adverse" scenario. The first test envisaged an unemployment rate of 8.4 per cent in 2009 and 8.8 per cent in 2010, while the "adverse" scenario tested for unemployment rates of 8.9 per cent in 2009 and 10.3 per cent next year. Yesterday, it was announced that 539,000 jobs were lost in April, meaning that the unemployment rate has already hit 8.9 per cent. "At the rate of job losses in the US today, we will surpass a 10.3 per cent unemployment rate this year - the stress test's worst possible scenario for 2010," high-profile economics professor Nouriel Roubini said this week.

Roubini's description of the tests as a "sham" was echoed by MIT professor and former IMF chief economist Simon Johnson, who said that the government's stress scenario was no more than a "mild and short-lived downturn".

The stress tests involved approximately 180 examiners analysing bank balance sheets over an eight-week period - too short, critics charge. "In that time period a team of that size would be able to examine the asset quality of two or three massive banks with plain vanilla assets," said William Black, an economics professor at Missouri university and author of The Best Way to Rob a Bank Is to Own One. A meaningful test is particularly complex, he said, adding: "There were no real examinations."

Black was one of many who criticised the "one size fits all" nature of the stress tests, arguing that this had "grossly understated derivatives risk", the "primary risk" faced by the biggest banks. The tests focused more on bank loan exposures than complex derivatives exposures, even though the latter is where the real systemic risk arguably lies. Warren Buffett, a shareholder in three of the banks forced to undergo the tests, was also critical of the "checklist-type approach". With different banks having different loan exposures and capital positions, this checklist method is invariably reductionist and ends up favouring some banks more than others, critics allege.

In essence, the different arguments amount to the same charge - that the stress tests were designed as a confidence-building exercise rather than an honest attempt to gauge the health of the US financial system. That impression hasn't been dampened by the fact that the US administration agreed to delay publication of the results at the banks' request, with banks managing to negotiate the ultimate findings with regulators.

Despite the reservations, the bullish mood of recent times remains undimmed. Besides the continued stock market advances, credit markets have noticeably thawed. Inter-bank lending rates, which soared in the aftermath of Lehman Brothers' bankruptcy last September, fell to record lows this week. The cost of protecting corporate bonds from default has fallen to levels not seen since the Lehman implosion.

The US administration is hoping that the banks will earn their way back to good health through government stimulus and debt. Currently enjoying fat margins as a result of rock-bottom interest rates and reduced competition, that may well happen. Analysts at Deutsche Bank yesterday said an economic pick-up would likely mean salvation for the US banking system. However, "if the data starts to level off at a still negative growth rate, then question marks will again be raised", they said. In other words, the banks are not yet in the clear, despite positive test results.

Ultimately, the tests were "not designed to really test anything", Simon Johnson charged. "They are designed to make it seem like the government has things well in hand."