Introduction
Bank stress test is test performed to evaluate the health of the bank and its readiness to endure the impending economic collapse. This test provides clarity to the investors on the health of the banks and in picking out the weak from the strong. Stress tests reflect conditions that are severe but conceivable. These are generally conducted by financial institutions and supervisors in their traditional risk management practices as it provides information on the vulnerability of the bank by examining how it might fare under different economic scenarios. Generally the macroeconomic factors used are real GDP growth rate, unemployment rate and the house prices growth rate. An adverse scenario of theses growth rates is assumed and its impact on the banks balance sheet is ascertained. The stress test entails the bank to project its credit losses and revenue and the level of reserves it would need to cover expected losses.

Stress test per se would not help to assess the financial health of the bank if not conducted properly. The adverse scenario may not have the same kind of impact on every type of asset. It would have a drastic impact on a risky asset and a milder impact on a less risky asset. All assets cannot be considered at par for the stress test irrespective of their qualities. Stress tests may be done to restore confidence in the financial system and to bring lending and raising capital back on track. However the tests should not be a ploy to restore the confidence. The ultimate motive should be not just to restore the confidence but to overhaul the financial system through effective regulation and review.

The US Banks Stress Test
US Government conducted stress tests on its 19 biggest banks, which hold two-thirds of the assets and more than one-half of the loans in the US banking system. As there is great uncertainty as to where the US economy is heading, the Government thought it would be sensible for the banks to hold additional capital so as to make them enough capitalized even in an economic collapse. The banks were asked to estimate losses, revenue and reserve needs in 2009 and 2010, including the level of reserves that would be needed at the end of 2010 to cover expected losses in 2011 under two alternative macroeconomic scenarios. One scenario was the baseline scenario, which reflected the consensus among professional forecasters on the depth and duration of the recession, while the other scenario was the adverse scenario, which was designed to characterize a recession that is longer and more severe than the consensus expectation. This exercise was expected to indicate the need for the banks to raise capital or improve the quality of their capital to endure the losses they may incur under worst situation. These stress tests were conducted by the Government to regain the confidence in the financial system. It may be good to conduct these tests but these may not serve as a substitute for prolonged supervision. They are just one-off tests, which would not help revamp the asset quality of the banks. The current financial crisis has been caused mainly because of poor quality of assets, the complex financial derivative assets which were held by the banks. So a careful examination needs to be done to review these assets and overhaul the balance sheets of the banks rather than just going for a stress test. The economic collapse would only exacerbate the banks balance sheets having these kinds of assets. So, more than stress tests a prolonged assessment of the banks balance sheets is required until the banks come up with a balanced portfolio of assets getting rid of complex derivative assets. Also the stress tests have been conducted in a span of 45 days, which seem to be largely insufficient for tests of that stature. The tests were administered by the industry based on the scenarios provided by the industry and the banks had to use their own risk models, which got them into trouble. The independent verification of the quality of accounting was lacking and the number of examiners per bank was well short. The results of stress tests may have profound impact on the financial markets, whether the results are positive or negative. However concluding whether the financial system is sound based on the results of the stress tests is spurious. But the effects of stress tests on the financial markets are two fold. If the stress tests reveal that the banks are sound and do not require to raise capital, then it’s good news for the markets at least in the short term as it may bring back some confidence in the financial system and the markets may start recovering. In case the stress tests reveal that some of the banks need to raise capital in order to equip themselves for the future disaster, then that may again be good news for the various financial institutions, involved in helping raise capital, as they can improve their underwriting income. So, in a way the stress tests apparently have a positive impact on the financial system at least in the short term. And the institutions required to raise capital may also have the option to request the same from the Government.

Government’s Investment in Financial Institutions
With the recent spate of bailouts, there has been a huge debate on whether the Government has to come to the rescue of the big financial institutions, once considered industry bellwethers, to restore the confidence in the economy. It is a sensitive issue as the tax payers money may be risked in the process. The Government, by helping these institutions, is exposed to a moral hazard as the institutions may lack the incentive to avoid unwarranted risks. Government has two modes of investing in these financial institutions – equity and debt. There could be different problems which could be perceived in these different modes of investment. If Government takes a majority control in any institution or if the institution is nationalized, then there is a risk that the Government could exploit the institution to gain political mileage by giving away cheap credits before an election. As such the institution can run into a risk of becoming a not-for-profit organization. However it would depend a lot on the attitude of Government in force. In any case extending unsecured credit to banks may not be an ideal solution as this would enable lenders to create more debt without diluting their equity. So, it would be wise for the Government to take something in return, may be in the form of equity stake for the debt they provide to the banks. It’s difficult to salvage the financial system by buying all the troubled debt of the banks and letting them run business as usual. This is what probably the US is doing right now by trying to bail out the banking and the auto industry. In fact the Government can nationalize the big banks if required and then try to introduce some effective reforms and regulations and through proper management can try to recuperate the health of the financial system. Once the financial system gets to its earlier state before the collapse, if not to a better state, the Government can sell the banks back to the market. The Government should expedite this entire process so as to refrain themselves from holding the banks for long. This would leave no room for the Government to exploit the banks for their political mileage. Also for the small and medium financial institutions, providing the debt in return for an equity stake may not be the right option as there would be too many small and medium institutions and Government may find it difficult to manage its investments in these institutions with limited resources available. So, the Government can encourage consolidation of these institutions by facilitating their acquisitions by larger institutions.

Conclusion
The Government as far as possible should try not to be long term investors in financial institutions. They may intervene in a state of economic collapse in an effort to restore the confidence in the system and may take a considerable stake in the behemoth institutions. But over a period of time, they must try to salvage these institutions to their earlier state and once successful in doing so, should dilute their stake by selling them to the market. This would enable them to make substantial gains on the tax payers’ money and in turn would help the tax payers in the form of increased subsidies.

This entry was posted on Friday, August 28th, 2009 at 5:53 am and is filed under Global Financial Markets, SGA Knowledge. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.