By William Isaac, Published by Forbes
The stress tests conducted in 2009 were a disaster.
Most of the reporting on the recent European bank stress tests accepts at face value assertions by U.S. political leaders that the stress tests conducted in the U.S. in 2009 were a rousing success in stabilizing the financial system. It seems that if you have a big enough megaphone and you repeat something often enough, it becomes conventional wisdom.
Far from being a stabilizing event, the public announcement of the stress tests on Feb. 10, 2009, by Treasury Secretary Timothy Geithner was terribly disruptive of the U.S. financial markets, which had just begun to settle down after the severe trauma in the fall of 2008.
Stress tests have been conducted by banks and their regulators for years, and they are important in managing and regulating banks. The decision by the U.S. to turn them into a public spectacle created a good deal of collateral damage. Take a look at the facts.
First, the public announcement created a firestorm. Which firms would flunk the tests and what would happen to them? Would they be nationalized or allowed to fail? Would the names and actual results for each bank be made public? Would anyone believe the results?
Second, the reaction in the markets was swift and highly negative. The Dow Jones Industrial Average, which had fallen like a rock from 10,800 when the TARP program was enacted in early October 2008 to 8,000 in mid-November, fell precipitously from 8,300 in early February 2009 to 6,500 a month later. The KBW bank stock index dropped from 31 to below 19 during that same period.
Third, the government was forced to do damage control so it declared in late February 2009 that none of the 19 stress test banks would be nationalized or allowed to fail. If the tests revealed the banks needed more capital it would be available from the government in the form of preferred stock.
Fourth, the announcement in early March 2009 that Congress would begin hearings designed to force the Securities and Exchange Commission and Financial Accounting Standards Board to curtail some of the most egregious aspects of mark to market accounting, coupled with the declaration that the 19 stress test banks were too big to fail, were major factors in turning around the U.S. markets. Fed Chairman Bernanke further assisted the turnaround when he declared in late February that commercial real estate loans should be valued based on expected cash flows, not declining collateral prices.
Finally, the repercussions of the government declaring the 19 stress test banks too big to fail are still being felt. Banks below the big 19 are having considerable trouble competing for funding and capital with the too big to fail banks.
Those are the facts. I am not aware of any evidence to support the notion that public stress tests stabilized the U.S. banking system.
The proponents of public stress tests have developed another theory for why they were needed. They say the tests forced large U.S. banks to issue new capital to strengthen their balance sheets.
In truth, U.S. bank regulators have enormous power to order banks to increase their capital. A stress test, particularly one conducted in public, is not needed for the exercise of this authority. It was the declaration that the 19 banks would not be nationalized or allowed to fail that enabled those banks to return to the markets to replace some of the capital that mark-to-market accounting had so senselessly destroyed.
The public stress test exercise greatly politicized bank regulation, as the Secretary of the Treasury and the president became involved in directing the tests. This political incursion into bank supervision frightens me greatly and will likely haunt us for years to come.
The good news is that the markets now seem to accept that public stress tests are little more than exercises in political theater, and they do not seem to be taking seriously the results of the tests in Europe. So we can hope that the collateral damage in Europe will be far less than it was in the U.S.