Untested Stress Tools at Center of New Debate

By Cheyenne Hopkins

Stress testing to determine which large banks need more capital sounds good, but these tools are often subjective, have not worked in the past, and could have unintended consequences. Little is known about how the Treasury Department plans to test the 18 largest banks, but to many the announcement was more about appearances than substance. The Treasury announced the stress tests last week as part of its broad overview of future plans for the Troubled Asset Relief Program. Other than saying the tests would be required only at banks with assets of more than $100 billion, the agency gave no details. The history of stress tests to date is not encouraging. Under the original Basel II rule finalized last year, banks had to conduct stress tests on their capital levels based on the past five years of market activity. But that led to overly optimistic results, said Karen Shaw Petrou, managing director of Federal Financial Analytics, who called the original stress test a “mess.” Also, the test “never looked at new products,” she said, allowing banks essentially to set their own capital standards on potentially risky new offerings. Ms. Shaw Petrou said regulators have already taken steps to correct the situation. The international Basel Committee on Bank Supervision released a proposal last month, which is out for comment until March 13, that details a new way to conduct stress tests. The proposal, which Ms. Shaw Petrou predicted would form the backbone of the Treasury’s plan, calls on using full business-cycle data, among other things, to test an institution’s capital levels. “The new one is a lot less subjective, because the old approach said ‘Make up your test and tell us how you are doing,’ ” she said. “The new one outlines a series of tests including extreme stress, and tells banks to tell regulators how they are doing under each test to determine who is most resilient. It puts the hard words on the spelling bee.”