Pundits cynical about bank stress tests

Needham, Massachusetts-based think tank Tower Group expressed concerns about the test methodology, saying it, “only touches the surface and lacks the substance needed to accurately measure the depth of banks’ resiliency.”

Rodney Nelsestuen, a senior research director at Tower Group noted the objective of stress tests is to get an accurate reading of a financial institution’s ability to survive additional spates of bad economic news.

“The assumptions made in the documentation of the stress testing methodology still fall short of capturing the dynamics of the industry going forward,” he said. “The approach being used can answer only the questions it asks, leaving many potential outcomes unknown and untested.” Those views are being echoed by pundits worldwide, in both the mainstream and financial press.

Tower Group’s comments listed a series of what they called “myths” about the benefits of the stress tests and the ability of the Troubled Asset Relief Program (TARP) to properly stabilize the financial sector. The group noted:

• Conversion of TARP finds into common stock is worrisome in light of the deterioration of credit portfolios and the current business climate. “It is irrational to think that financial service institutions 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,” the report said;

• Investors may not view common stock primarily as a cushion to absorb losses, since they largely buy those stocks in search of dividends and share appreciation. It also notes the program doesn’t take into account that millions of U.S. citizens become shareholders via mutual funds and 401(k) programs. So, according to the report, the assumptions mischaracterizes the public’s view of equities in public companies;

• The stress tests essentially take place in a time vacuum and don’t look forward to future changes in employment levels, gross domestic product growth, or other economic factors. Therefore, the idea that this one series of tests is the final word on bank health is flawed. Rather, they say, banks will have to conduct their own periodic stress tests and be accountable for covering systemic risks; and

• There should be reverse stress testing to help banks determine how they fell into the current crisis, with an eye toward setting plans to avoid future downfalls.

Tower Group added the stress testing will confirm suspicions about the underlying differences among various nations’ regulatory approaches to bank stability and recapitalization. Further, it said the world financial community is placing too much emphasis on the tests.

“The current testing is not a means to an end, but merely the beginning of efforts to rebuild the banking industry,” Their report said. “[Financial institutions] must look beyond passing the tests if they are to make the right moves, rebuild their business fundamentals and emerge stronger and healthier from the crisis … [institutions] will need to upgrade their risk management capabilities and regain the confidence of customers, long-term investors, and other stable sources of funding.”

(05/06/09)