Where's the Beef?!?!

Posted by Mark Brousseau

On Friday, April 24, US regulators revealed the methods and criteria used for stress testing the nation's largest banks to determine their financial health. TowerGroup, a leading financial services research and advisory services firm, believes that current stress-testing methodology is "a bun without the beef," observing that the current process only touches the surface and lacks the substance needed to accurately measure the depth of banks' resiliency.

From an international perspective, TowerGroup believes the latest revelations from the US will do little to reengender confidence in the international banking system. Instead, stress testing will confirm suspicions about the underlying differences among various nations' regulatory approaches to addressing bank stability and recapitalization.

"The stress testing of banking institutions is a major undertaking that turns traditional testing by means of "what if" scenarios on its head with its far-reaching assumptions. However, the assumptions made in the documentation of the stress testing methodology still fall short of capturing the dynamics of the industry going forward," said Rodney Nelsestuen, Senior Research Director in the TowerGroup Financial Strategies and IT Investments Cross Industry research service. "The US government is trying to get an accurate reading of an institution's ability to survive more bad economic news. The approach being used can answer only the questions it asks, leaving many potential outcomes unknown and untested."

TowerGroup notes several misguided views the public may infer from the documents released by the Fed last Friday and explains the reality that is counter to each view:

Myth 1: The option to convert TARP to common stock should provide comfort to stakeholders.Reality: One of the most worrisome motives behind stress testing is the intended conversion of Troubled Asset Relief Program (TARP) funds into common stock. Given the continuing deterioration in credit portfolios and faltering business performance, it is irrational to think that financial service institutions (FSIs) are safe because their capital is adequate due to government assistance when the assistance also increases government control and hampers the performance of independent banks.

Myth 2: Common stock is mainly a cushion to absorb losses. Reality: Investors buy common stock hoping to earn dividends and benefit from share appreciation over time. The government document on stress testing ignores the fact that millions of people in the United States are also shareholders through mutual funds and 401(k) programs. Thus, to say that common stock exists to absorb losses mischaracterizes the overall role of common equity in any publicly held company.

Myth 3: The regulatory actions are not shortsighted. Reality: The current stress test is a single exercise tied to a specific point in time, which is then applied to forward-looking economic criteria such as unemployment, growth of the US gross domestic product (GDP), delinquencies, and counterparty risk. TowerGroup observes that a major risk exists if people come to see the current stress-testing exercise as the final word on bank safety. Banks will need to assume the responsibility for their own stress tests and be accountable to stakeholders, of which the government is but one. Consistent internal testing will alert banks to potential systemic risks, allowing them to react before such events reach crisis proportions.

Myth 4: The absence of reverse stress testing is immaterial.Reality: Nowhere in the current stress-testing methodology document is reference made to reverse stress testing. Under the current approach, assumptions are changed to see what impact they have on bank viability. Reverse stress testing encourages more creative thinking to determine what events could have occurred to bring about the current economic downfall. Reverse stress testing would force the government and institutional leaders to think more broadly about cause and effect.

Myth 5: Stress testing is the final arbiter of financial strength.Reality: Verbiage in the stress-testing methodology document calls into question the stress-testing process used and any results to be derived from it. The cautionary statement is needed. Public anticipation of the stress-test results to be released on May 7 continues to be heightened, and the government is not doing enough to reduce that overreliance on the pending results. In addition, regulators have left themselves an out and can either justify or discount the outcome. The current testing is not a means to an end, but merely the beginning of efforts to rebuild the banking industry. The pending May 7 news should not be considered gospel in determining a bank's future success or demise. It is an attempt at identifying means for greater transparency and modernization.