The Economist: Stress testing America’s banks. Not as good as they look.

The Federal Reserve’s stress tests have shown at least two banks to be wobbly

By Tom Easton

At first glance, the results from the Federal Reserve’s stress test of America’s 31 largest banks, released on March 5th, seem to suggest a clean bill of health. The test takes the banks’ balance-sheet data and subjects it to a variety of economic catastrophes, such as a 60% drop in share prices and the unemployment rate reaching 10%.

No bank was found immediately wanting. But on second look, however, two banks came close to breaching the minimum level of capital they required. These were Goldman Sachs and Zions Bancorp. Zions has had problems with stress tests before. But the close call at Goldman was a surprise because it is thought to manage such things too adeptly to ever demonstrate a possible vulnerability.

These results have also raised questions about how these two banks will be judged in the second round of the tests, due to be released on March 11th. This takes into account their planned distribution of capital through share-buybacks or dividends. If these payouts reduce Goldman Sachs or Zions’s capital buffers too much, they may be forced to change their plans. Holding onto more capital may satisfy regulators, but it also dilutes the banks’ return on equity. This is a serious issue at a time when their financial performance is already lacklustre and investor pressure to break up banks growing.

Worse still, other banks may fail the next round’s qualitative tests. Taking into account subjective evaluations about how they manage their capital, the American units of Deutsche Bank and Santander are expected to fail. The initial round showed them to be well-capitalised in quantitative terms. But even the perception of weakness damages market confidence in them, which means they have to pay more for capital. Santander, perhaps as a pre-emptive move, has already announced changes to its American management.

But although financial markets are taking the stress tests seriously, many outside the Federal Reserve are questioning their usefulness. They will turn out to be “a classic example of a regulatory Maginot Line, which will be precisely irrelevant for the next crisis,” says Ralph Segall at Segall, Byrant & Hamill, an investment firm. There are other unintended consequences as well, banks say, as concerns about passing stress tests makes them favour government bonds over business lending, which would harm the growth of the private sector. Tests on whether that is good for stability in the long run are, so far at least, not part of the regulatory agenda.

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