What Is Stress Testing?

It is a big week for America's 20 largest banks, as the Obama administration begins a process of stress testing these beleaguered financial institutions. Ever since Treasury Secretary Tim Geithner's uninspiring performance on February 10, the markets have been scrambling to determine what the new financial rescue plan might look like. Even preliminary estimates suggest that Citigroup, Bank of America, Wells Fargo, JP Morgan Chase, Goldman Sachs, and Morgan Stanley all might need additional support from the government.

Much has been written about the murky details of Mr Geithner's public-private investment fund. Indeed, few analysts are convinced that the administration has announced little more than a plan to make a plan. More alarming, however, is the swirling doubt over the imminent stress tests, which appear to be one of the few concrete measures in TARP II. The government has said that these balance sheet evaluations will run a series of "what if" models that will simulate a bank's performance under increasingly adverse conditions (rising unemployment, falling home prices). Still, many are wondering: how will these stress tests work?

In general, stress testing models the valuation of capital under situations that are costly and rare. These test often simulate shocks at a greater intensity than historical data would otherwise suggest and simulate shocks that have never previously occurred. Under Mr Geithner's logic, such an exercise would help Treasury learn which banks are equipped to weather the financial storm, and which are insolvent. The results of the stress tests will not be made public (the institutions that fail could face nightmarish bank runs), the administration hopes to determine where its capital injections are best spent.

Here is the problem: for all intents and purposes, there will be no real stress tests. First, the sheer cost of true stress testing is prohibitive. The process involves an accounting process that would dwarf the post-Enron clean-up, and there is not remotely enough manpower or resources. What is more, a true stress test would almost assuredly require an increase in capital requirements for banks (precisely the opposite of what Mr Geithner wants).

Second, it is unlikely that any of the bank regulators dispatched to perform these stress tests are qualified to analyze today's byzantine financial instruments. The national crash-course in credit derivatives and structured products does not even begin to understand the toxic assets that have torpedoed our economy. A true stress test would measure the cascading consequences on liquidity and contagion of, say, credit default swaps; however, regulators familiar with traditional banking activities are (understandably) clueless on how to price these securities in the current market.

Third, there are reasons to suspect that there is real accounting fraud in the financial services industry. In the age of Bernie Madoff and Allen Stanford, it is somewhat surprising that more attention has not been paid to this scenario. Is it so inconceivable that the $100 billion hole in Lehman's balance sheet was criminal? Real stress tests will have to compare accounting numbers with the underlying documentation (original loan files). Often times, however, these documents are missing as subprime loan originators went bankrupt and simply discarded the files. In the nightmare scenario, crooked accounting practices will further obfuscate the stress tests.

At this point, most observers agree that any viable economic recovery plan requires clarity and commitment. The Bush administration was pilloried for its on-again-off-again responses to the financial crisis. In an effort to chart a new course, Mr Geithner had hoped to lay out a convincing bank rescue plan when he spoke two weeks ago. Unfortunately, the underlying specifics of his message are, at best, underwhelming and, at worst, entirely absent. It is time for new solutions for the banking system, the type Americans are culturally predisposed to abhor. Pre-privatization, anyone?