The results of the Supervisory Capital Assessment Program -- sorry, the stress tests -- are out. You can download the full release here.
I've actually gotten the feeling in recent days that there's a bit of confusion over what the stress tests actually represent. In short, the stress test was an examination of how the bank would perform under further, well, economic stress. It's not how much capital the bank is expected to need. It's how much capital the bank is expected to need if things get worse. To quote the official release, the government set out to "measure how much of an additional capital buffer, if any, each institution would need to establish today to ensure that it would have sufficient capital if the economy weakens more than expected."
That "more than expected" gets you to the ambiguity. Expected by whom? The Federal Reserve argues that their "adverse scenario" was, quote, "deliberately stringent." In other words, the Federal Reserve says it was being, if anything, too tough. Others would argue it wasn't nearly stringent enough. The IMF thinks banks are going to have to write off hundreds of billions more in loans than the Federal Reserve is predicting. Nouriel Roubini estimates that banks will have to write off hundreds of billions in loans than the IMF is predicting. If either one is right, the stress tests are going to look pretty bad a year from now.
But you also have to understand the stress test as having a purpose beyond a simple analysis of bank assets. That was part of it, of course. But the tests were also designed to reassure the market. If the market believes the results and now believes the banks only need $75 billion to be sound even under "adverse" conditions, and that the banks will raise that $75 billion by hook or by crook, then that will make it more likely that the market won't deteriorate and conditions won't be as adverse as they otherwise could be. Confidence matters. And this has certainly been evident in the administration's press strategy.
On the other hand, that can also be a dangerous game: If the stress test proves overly optimistic and the market later has to deal with these banks collapsing, then the government loses credibility when it pronounces banks sound or releases the results of an evaluation in the future. And though I'd caution folks not to read too much into this, the Dow is down more than 100 points today, suggesting that this release hasn't exactly allayed all fears. But the market's real judgment should come in the next few months as these banks try and raise private capital. No one is going to loan to an institution that they think will go under.
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