Getting Stressed

Over at The Baseline Scenario, several contributors are laying out the parts of the banking “stress tests” that should receive careful public scrutiny when the results are released later this week.

On the idea of the stress tests:

There is nothing wrong with the concept of the stress tests, and arguably regulators should have been doing them constantly as the crisis worsened, so that this particular iteration would not create such a political challenge. The idea is that not only do you want to know how much capital a bank has right now, but you want to know how much capital it will have left if the economy continues to get worse. If you did this analysis in a way that was credible with the market, it would go a long way toward restoring confidence in the financial system, since the current lack of confidence is based on people’s not trusting the information they are getting.

On the limitations of the stress tests:

However, right now the stress tests face a number of risks:

* They have partially undermined themselves by using a “more adverse” scenario that is roughly in line with what most forecasters think is actually going to happen, so they are not very stressful.

*The administration has already as much as said that the banking system is well capitalized and no banks are going to fail, which makes it seem like the results are preordained …

* Most importantly, the announcement of the results was delayed so that the administration could negotiate with Citigroup and Bank of America over their report cards, which does not exactly foster confidence in the results that will eventually be announced. The term “stress test” was borrowed from medicine; do patients negotiate with their doctors over their diagnoses?

On the politics and public perception of the stress tests:

After long negotiations, the bank stress tests were set to show most banks are close to have their Goldilocks level of capital (i.e., just right)  Given that we generally agree (and the President has long stressed) this is the biggest financial crisis since the Great Depression, we seemed to be on the the verge of a capital adequacy miracle.

But instead of this being seen as some combination of good luck and smart policy, ”everyone is basically fine” would look like the banks are running the show…. Whatever the reality, it looks increasingly to everyone like the banks really are in charge.

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