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Bank Stress Tests: The Treasury's Conundrum

Originally, today was supposed to be the day that the results of the bank stress tests were publicly released. Now those results are expected Thursday.

The stress tests were first announced by Treasury Secretary Tim Geithner on Feb. 10 as a key component of the overall financial stability plan. The idea of stress tests is both simple and sensible. We are deep into what will probably be the most severe recession since the 1930s, which hurts the value of bank assets as borrowers run into difficulty repaying their loans.

Bank regulators should want to know whether major banks will be able to withstand the recession without becoming insolvent. The stress tests should estimate the impact of a severe recession on bank balance sheets and determine which banks will need more capital (erring on the safe side); regulators should then tell those banks to raise the additional capital, from the private sector or the government.

However, everything about these times is unusual.

From a regulatory perspective, the goal is to determine which banks will fail a worst-case scenario and force them to take preventive action. But at the same time, the Treasury Department is trying to restore confidence in the financial system. This objective breaks both ways. Confidence is low today in part because markets suspect that the banks are under-capitalized, but are not sure. So in the long term, rigorous stress tests that the public has confidence in should boost confidence by making clear that at least some banks are healthy, even if they reveal that some banks are sick.

But in the short term, labeling specific banks as sick would effectively cause runs on those banks, putting them into immediate danger and possibly triggering ripple effects on other financial institutions. (Although deposit insurance should rule out the possibility of people lining up to withdraw their deposits, runs can still occur in other forms, for example as hedge funds withdraw their business from a troubled bank.) This is an outcome that the Treasury desperately wants to avoid.

And so they have a conundrum.

On top of that, almost three months have passed since the stress tests were announced -- three months during which the Treasury has needed to shore up confidence in the financial system. So, on April 21, Geithner told the TARP Congressional Oversight Panel that "the vast majority of banks have more capital than they need to be considered well capitalized by their regulators." Paul Krugman immediately pointed out that this is, technically, a meaningless statement because the United States has thousands of banks, and what we really care about is whether the majority of bank assets are held by well-capitalized banks. But to the general public, the Treasury has put itself in a position where it cannot announce that the banking system is significantly under-capitalized.

Then there is a matter of simple arithmetic. The International Monetary Fund has estimated that U.S. banks will require $275 billion to $500 billion in additional capital. Only about $110 billion remains from the original TARP funds, and Geithner has said he expects $25 billion in repayments, giving him $135 billion. And there is currently no chance that Congress will release more money for bank bailouts. So if the stress tests indicate that the banking system needs more than $135 billion, the Treasury is in a bind.

So alongside the mystery of the tests' results, there is an equally big mystery: how much information the government will reveal. As recently as Thursday, the plan for how to release the results was "not very far along." The key issue seems to be how much the results will differentiate between healthy and "less healthy" banks. (Don't expect to see the word "sick" coming out of Washington.) Again, the fear is that banks singled out as weak will face a loss of confidence by investors and counterparties. This is why, ever since the first round of re-capitalizations back in October, the government has insisted on treating all banks as one undifferentiated mass. But if the regulators simply say that all banks are healthy, then the purpose of the entire exercise would be defeated.

Tough problem.

Fortunately or not, however, the government may find that problem solved for it. Information about stress tests has already started to leak out the old-fashioned way. Even without leaks, there are other ways for banks to signal their results. Goldman Sachs, for instance, made a show of raising private capital, issuing new debt without a government guarantee, and offering to repay its TARP money. Jamie Dimon of J.P. Morgan Chase also announced that he could repay his company's TARP money. In both cases, this is code for "We're going to pass those stress tests with flying colors," and the goal is to sow doubt about competitors.

The Treasury has reason to want to minimize distinctions among the large banks. But now that the banks have the knives out for each other, it's hard to see how Geithner can hold the line.

This week should be interesting.

By James Kwak  |  May 4, 2009; 6:17 AM ET
Categories:  Banking  
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