Friday, April 17, 2009

This could further stigmatise the weaker banks

TO BE NOTED: From the FT:

Pressure to toughen stance on banks

By Krishna Guha in Washington

Published: April 17 2009 22:00 | Last updated: April 17 2009 22:00

Rising unemployment is increasing the pressure on US authorities to take a tougher stance in judging the results of bank stress tests, a development that ultimately could force leading financial groups to hold more capital.

The stress test process is intended to ensure the big US banks have enough equity capital to survive comfortably a recession that is worse than officials at present expect – a so-called “adverse scenario”.

When the stress tests were first unveiled two months ago, the authorities defined the adverse scenario as one in which unemployment rose gradually to peak at 10.4 per cent in late 2010.

But since the announcement was made, unemployment has risen much more quickly than anticipated even under the “adverse scenario”. The Federal Reserve and a number of other economic forecasters also revised down their forecasts for growth over the next two years during this time.

The upshot is that the likelihood of unemployment reaching 10.4 per cent as envisaged in the “adverse scenario” looks higher than it did at the onset of the exercise – making the stress test, in other words, appear to be less stressful.

The authorities believe it is too late to revisit the assumptions underpinning the stress tests. However, it is not too late for them to decide to interpret the implications for capital more stringently.

Making such an adjustment would help rebut claims by critics such as Nouriel Roubini, chairman of RGE Monitor, who wrote on his blog: “The stress test results are meaningless as actual data are already running worse than the worst-case scenario.”

No decision to change the way the tests will be interpreted has yet been made. Even if officials do lean in this direction, it may never be visible, because they did not specify in advance any precise formula relating stress test outcomes to required bank capital.

Moreover, signs of economic recovery could persuade policymakers to disregard the rapid recent rise in unemployment on the grounds that it might revert to the less alarming trajectory they originally expected.

Policymakers also believe that other assumptions in the test – such as those for house price declines – still reflect a worse-than-expected outcome. Nonetheless, unemployment is an important driver of loan defaults.

At the same time, administration officials are pressing wary banks and regulators to agree to disclose summary details of the stress test assessment of each bank’s assets, possibly using a common template.

They believe this information would help markets evaluate the financial health of each bank as well as reinforce the credibility of the stress test. They do not think even weaker banks could benefit from hiding the results from the market, since investors would probably fear the worst.

However, they want to avoid a disorderly situation in which the stronger banks advertise the results of their stress tests, while weaker banks resist doing so. This could further stigmatise the weaker banks."

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