By William Isaac, Published by American Banker

The government’s program to conduct stress tests on the 19 largest banks has led to endless media hype and considerable stress for banks. Professional bank regulators and bank executives have been stupefied about the program since it was announced by Treasury in February.

Stress tests have been conducted at major banks for decades. It’s an important element in the supervision of banks and in banks’ own risk management programs. While I would not find fault with regulators deciding to undertake new stress tests of the largest banks using uniform assumptions, the public announcement of the tests was a stunning mistake.

Did the government not envision that the media would jump all over the story and stay with it for months, providing short sellers (which the SEC has still not re-regulated) another field day? Did the government not anticipate that the announcement would lead to calls for public disclosure of the results, which would have enormous downside potential with no obvious upside?

If the government refused to disclose the results, people would assume the worst. If the government announced that everyone “passed” the test, many would assume a cover-up. If officials announced that some banks “failed” the test, there would be a clamor for names, the release of which could prove disastrous.

Having put itself between a rock and a hard place, the government decided to announce publicly that none of the 19 banks will be allowed to fail – that taxpayers will bail them out if they need additional capital. The losers in that scenario, besides the taxpayers, are the banks smaller than number 19. If I’m bank number 20 or 25, I’m not too happy to learn the
government has anointed my larger competitors too big to fail while I twist in the wind.

Where does this stop? Are all banks going to receive stress tests, and are all banks going to be protected against failure? If we stop short of protecting all banks, how do we justify the competitive injury to those that are deemed small enough to fail? Stress tests involve guesses about the future, and they can be wrong in either direction, just as risk-based capital models and bank examinations can be wrong. If models were always
right, we wouldn’t be in the mess we are in today.

It appears that the government has concluded that all 19 of the large banks have adequate capital today. Apparently the government also says that some of them might not have enough capital to weather a “severe” economic scenario.

The banks that cannot weather the severe scenario apparently must shrink, raise private capital, or accept more taxpayer capital. Shrinking the largest banks in the country is hardly consistent with the government’s call for them to increase lending and help lift us out of
recession.

Forget about raising meaningful private capital for these banks any time soon, particularly after the government has placed restrictions on dividends, executive compensation, marketing activities, and even gatherings in nice locales to reward top performing employees.

So it appears that taxpayers will get hit up again. As a taxpayer, I might accept that outcome if it were based on actual events rather than speculation derived from models no one has been able to perfect.

Moreover, I would feel a lot better about the government using my money in this fashion if it had ordered the Financial Accounting Standards Board to cease its senseless and massive destruction of bank capital under mark-to-market accounting rules that virtually all bank regulatory experts believe represent very bad policy. FASB’s recent so-called reforms have fallen far short of what is needed.

Perhaps the worst aspect of the financial crisis is that the politicians have seized control of the regulation of banks. Bank regulation and crisis management is being dictated by the Treasury and the White House instead of the independent banking agencies established for that purpose. No good can come of this.

Political intervention leads to blunders like playing out bank supervision in the public arena. Apparently our collective memory doesn’t stretch back two decades to when intervention by the Administration and Congress played a major role in creating the S&L debacle, which cost taxpayers $150 billion.

If we want to heal our financial system so it can resume the business of financing the economy, the Treasury and the White House need to get out of the way and return the authority for bank supervision to the professionals at the independent banking agencies.