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Thursday, May 21, 2009

"Near Sighted Stress Tests"

Lucian Bebchuk argues that banks "could well be in much worse shape than has been suggested by the stress tests" because the tests only looked at losses through the end of 2010. Anticipated losses after that date, which could be big enough to matter, were not included:

Near-Sighted Stress Tests, by Lucian Bebchuk, Forbes: Buoyed by the results of the "stress tests" conducted by banks' supervisors, markets now appear optimistic about the capital positions of U.S. banks. Unfortunately, however, this renewed optimism has a shaky foundation. By design, the stress tests have avoided estimating the declines in the value of many toxic assets owned by banks. As a result, U.S. banks could well be in much worse shape than has been suggested by the stress tests.

The report announcing the results of stress tests stresses that supervisors conducted "a deliberately stringent test" and examined the ability of banks to absorb losses even under an "adverse" scenario... The report concludes that, with a modest aggregate addition of $75 billion in common equity, the banks will be well capitalized at the end of 2010 even under the adverse scenario. ...

However, for a bank that has "troubled assets" ... that do not become due until after 2011, supervisors did not attempt to come up with a precise estimate of the extent to which, at the end of 2010, the economic value of the troubled assets will fall below the $1 billion face value.

This approach overlooks a substantial amount of economic damage imposed on banks by the crisis. Indeed,... even if banks are able to avoid recognizing these declines in value on their financial statements until after 2010, there will still be such economic losses. A bank may be an economic zombie even if its financial statements do not yet show it.

The report acknowledges this major problem in a footnote, noting that its estimated losses "are not full lifetime losses … because the projections are for a two-year forward horizon and thus do not capture losses occurring beyond the end of 2010." ...

To get a full picture of the banks' situation, bank supervisors should estimate also the decline in the economic value of banks' positions with longer maturities. Only then will the stress tests be able to deliver reliable figures for the additional capital necessary to make the banking sector healthy and vigorous. Until such an analysis is done, it would be important to avoid the premature conclusion that the U.S. baking system is largely out of the woods.

    Posted by on Thursday, May 21, 2009 at 02:11 PM in Economics, Financial System, Regulation | Permalink  TrackBack (0)  Comments (3)

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