Bank Stress Test Results

Douglas J. Elliott

The financial “stress tests” on the big banks gave us good news: they “only” need $75 billion of new capital. That’s a lot of money, but much less than many of us feared. However, it is important not to take excessive comfort from what is essentially a highly educated guess as to the future of the banks in a very uncertain environment. We’ve never been in a crisis like this and we simply don’t know how it will play out. If the stress test’s estimates of the value of the banks’ assets at the end of 2010 were off by just 3%, we’d need another $300 billion of capital.

What you think about the stress test results depends heavily on how tough you think the test was. My own view is that, everything taken together, there is roughly a two in three chance that the banks will do as well or better than the stress test results. The problem is that the other one in three chance includes some very painful possibilities, such as those projected by Dr. Nouriel Roubini of NYU, who is probably the most pessimistic of the analysts who have made really detailed loss estimates.

The stress test was somewhat tougher than the projections of the International Monetary Fund (IMF) which has done a very thorough analysis that epitomizes the “consensus” view by economists of the banking system’s near-term future. The IMF analysis implies about $300 billion of credit losses still to come at the big banks, which would be covered by about $200 billion of new earnings, excluding those credit losses, plus about $100 billion of new capital that has been or will soon be raised. In other words, the IMF figures imply that the banks have about bottomed out. (See my paper, “Implications of the Bank Stress Tests,” for more details.)

Many people have the perception that the IMF figures were much larger, so let me briefly explain the $300 billion in credit losses. The IMF believes there will be massive credit losses worldwide of $4.1 trillion. However, all but $1.1 trillion of that will fall on foreigners and non-banks. Half of the remainder are losses that have already been taken. When you scale down the remaining $550 billion to represent the share of the 19 banks in the stress test, it comes down to $321 billion, by my estimate.

So, the stress tests were tougher than “consensus” estimates. However, it was not nearly as tough as the projections of the real pessimists. Roubini’s loss estimates imply not the break-even results from the IMF, but a need for almost $500 billion of additional capital. If he is even close to being correct, we are far from finished with the solvency crisis at the banks.

Even if the big banks are indeed now strong enough to survive reasonably soundly without raising large amounts of capital, it does not mean the credit crunch is about to end anytime soon. The test was to see if banks could hit their target minimum capital ratios by the end of 2010 at their current size, which implies roughly their current level of lending. If we find ourselves in the stress scenario or worse, which is maybe a one in three chance, banks will not have room to expand their lending and may need to contract.

What makes this much worse is that the “shadow banking” market used to provide about 40% of all loans, but has contracted very sharply. We need the banks to be strong enough to fill the gap by making more loans and keeping them on their books. This would require far more capital, which will only become available when the financial markets become much more willing to fund the banks at reasonable prices. Bank stocks are doing much better in the last couple of weeks, but the market is far from strong enough to handle hundreds of billions of dollars of new capital requirements at the banks.

The stress tests also mean that it will be even harder to successfully implement the government’s new programs to deal with toxic assets. The banks are generally unfavorable to this program and the test results will ease the pressure on them to participate. They believe that private investors, even with generous incentives from the taxpayers, will not be willing to pay what these distressed assets are actually worth. The banks genuinely believe that while the assets have lost a lot of value, they remain worth perhaps 60% of their face value on average. Investors were willing to pay about 30 cents on the dollar before the programs and the incentives might kick this up to 40 or 45 cents.

It is going to be hard to push most of the banks to participate, since the stress test just said they will have enough capital to get through even a tough economic environment, while holding onto the toxic assets. Regulators in America have the right to push banks to do things that are necessary to keep them solvent, but not to overturn business decisions otherwise. In practice, a few of the big banks are highly vulnerable to regulatory pressure and may participate for that reason. The others may choose not to play or will do so only halfheartedly.

All in all, the stress tests were useful and the results were encouraging. However, we have a lot of pain to get through before this crisis is over. If we’re lucky, it will remain bad for awhile. If we’re unlucky, and Roubini is right, it could still get extremely ugly.