Public scrutiny blunted bank stress tests

[May 06, 2009]  NEW YORK (AP) -- Treasury Secretary Timothy Geithner said in February that putting the nation's biggest banks through "stress tests" was vital to getting the financial system back on solid ground.

But with the results set to be released Thursday, critics say regulators seem so intent on avoiding statements that might undermine confidence in the banks that they risk eroding trust in the stress tests themselves.

Regulators say none of the 19 banks will be allowed to fold. That rules out any official statements that might scare investors. As a result, critics say the results won't likely provide the specific analysis and discipline banks need to lend money and nourish an eventual economic rebound.

The public spotlight on the tests "negates the whole point" of stress testing, because regulators know tough action could imperil the banks, said Jaidev Iyer, a former risk management chief at Citigroup Inc. who now works at a nonprofit involved in bank risk analysis.

The tests of the 19 largest financial firms are at the center of the Obama administration's plan to stabilize the financial system. The tests estimate losses banks would face in a "what-if" scenario involving a worsening recession: 10.3 percent unemployment and a 22 percent drop in home prices over the next two years.

So far, investors seem unfazed by reports that the tests found some banks would need to raise capital to absorb possible future losses. A handful of banks among the 19, including Bank of America Corp., Citigroup Inc. and Wells Fargo & Co., would need more capital based on initial findings, sources have told The Associated Press.

The Wall Street Journal reported early Wednesday that Bank of America's capital shortfall stands at about $35 billion, which would make Charlotte, N.C.-based BofA potentially the bank with the largest capital needs.

Regulators and internal auditors routinely use stress tests to manage bank risk. The tests, typically done in private, help guide investments and ensure the banks' stability. Normally, regulators disclose their evaluations and remedies with banks behind closed doors. By contrast, critics say, the Fed's approach seems designed for public consumption.

Open discussion of the stress tests, from the White House on down, has made it hard for regulators to be as candid as they'd like, said Bradley Sabel, a veteran bank supervisor with the Federal Reserve Bank of New York now at the law firm Shearman & Sterling.

"I think there's an awful lot of value in keeping confidential the discussions between banks and examiners," he said.

Fear of igniting a market panic means regulators aren't likely to force banks to make major changes in their operations and investments, Sabel said.

The administration has repeatedly called attention to the stress tests. For weeks, officials have brushed off questions about the health of the banking system by mentioning the forthcoming test results.

Asked last month about a Treasury program to buy banks' troubled assets, White House adviser David Axelrod said, "Let's see what happens once the stress tests are done and the capital needs of banks are determined."

Simon Johnson, a former chief economist with the International Monetary Fund now at the Massachusetts Institute of Technology's Sloan School of Business, said the tests may have served the administration's political needs.

"The stress test was a clever stalling action from a tactical point of view," Johnson said. "They wanted to wait until the economy showed signs of bottoming out. Now, everyone's more relaxed, and they can go easier on the banks."

Asked about the tests, a senior government official familiar with the process said they were designed to illuminate the health of the banking system. The results will be clear and detailed enough for investors to make informed decisions, said the official, who requested anonymity because he wasn't authorized to discuss the matter.

The difficulty of operating under public scrutiny was clear almost from the day Geithner announced the tests, said Kevin T. Jacques, a longtime Treasury employee who's now a finance professor at Baldwin-Wallace College.

"I think Treasury got backed into a corner," Jacques said. "It felt, 'The market is clearly aware we're doing these tests ... If we don't release the results of the stress tests, the market will think that we're hiding something.' "

Providing more information about the health of banks is a worthy goal, said William Seidman, who ran the Federal Deposit Insurance Corp. during the savings-and-loan crisis. But he said the best way to do so would be to tailor the tests to each firm. Among the 19 firms being stress-tested are an insurer, an auto finance giant and banks with diverse business models.

Applying the same scenarios to 19 firms makes little sense, Iyer agreed. A"one-size-fits-all approach" doesn't take account of the strengths and weaknesses of each bank's assets.

"I am very skeptical that we will learn much about the true conditions of these banks," he said.

Billionaire investor Warren Buffet made a similar point over the weekend. He said the stress tests focused on banks' debt -- not on whether their operations were basically strong.

Federal Reserve Chairman Ben Bernanke told lawmakers Tuesday that the tests will help banks develop plans to raise their capital buffers if necessary. The extra capital would ensure the banks could keep lending even if the recession worsened.

A functional financial system will be crucial to any economic rebound. Until banks can return to normal lending, it will be hard for companies to expand. And it will be tough for consumers to make the purchases that would spark a recovery.

Yet there's no guarantee that forcing banks to boost their capital reserves will have the desired result, Seidman said. He said the government should take control of banks that might fail and clean up their balance sheets by seizing assets that have lost value or can't be sold.

Iyer said he worries the tests have become too tangled in fears of political or economic aftershocks to do much good.

"I'm a little concerned that somewhere in there, we've lost complete sight of the meaning of this exercise," he said.

[Associated Press; By DANIEL WAGNER]

AP Economics Writer Jeannine Aversa in Washington and AP Business Writer Madlen Read in New York contributed to this report.

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