So, the veil is off – or at least it’s lifted a bit. On May 4, we’ll know who passed and
failed the stress test. Yes, we know it’s an all-pass test – Treasury has repeatedly assured
the market that the stress test won’t really stress anyone because it will just suggest how
much capital a bank might care to raise. That version of the stress test strained credulity,
though. As it became indisputable that not all banks could slide through with just a
capital touch-up or two, the results became clearly material events. If the banks or
Treasury didn’t release the stress test’s results, then the market would guess them and
that would lead to still worse volatility sparked by ongoing uncertainty.

When the stress tests were announced for the nineteen biggest banks, Chairman Bernanke
told Congress that its results would be disclosed. This was promptly refuted by Treasury,
which made clear that the results would be confined to a chosen few. Under this
approach, the results were to be treated like any examination’s conclusions and closely
guarded from public scrutiny. Banks worried though that this legal protectionism
afforded exam results would not protect them from the stress test because of its clear,
immediate consequences. More importantly, banks that expect to pass the test with
flying colors – and we think there are at least a couple – believed they would be dragged
right back into the muck of market fear if Treasury tried to obscure the results .
Whatever Treasury attempted, the market would surely out-guess it by seeing who was
going where in the market for how much capital from whom.

This bit of transparency on the stress test will thus be of considerable value to sound
banks – again, there really are some. It will also ensure discipline for the weaker ones – a
long-overdue bit of sanction from federal regulators. The disclosures thus reinforce a
point we’ve made in the past: regulators shouldn’t shirk the market discipline they tout
for the industry. Their conclusions can and should be made public.

Going back to 2001, we testified to Congress that CAMELS ratings should be disclosed
and we still think this would be a good idea. Regulators have long opposed this because
they fear panicky flight from weak institutions to strong ones. In fact, regulators have
been so frightened of depositor and investor judgment that they’ve even kept enforcement
orders – which must generally be made public – under wraps. However, all this fear has
contributed to the costly contretemps in which banking now finds itself: without
knowing who was sound or weak and to some degree trusting in too-big-to-fail implicit
guarantees, the market hasn’t had to differentiate among banking organizations until the
fear came upon them. At that point, weak banks were far too large to handle with care
and the rest, as we sadly know, is history.

If uninsured depositors, counterparties and investors can see regulator judgments, then
they can rationally assess them and start to protect themselves long before a bank slides
into the abyss. If a bank goes from CAMELS 1 to 2, for example, pricing can and should
change. This will create strong incentives for banks quickly to get back in regulators’
good graces even though the downgrade isn’t so steep that any knowledgeable
counterparty would fear imminent default. If banks slip from 2 to 3 and farther down,
then counterparties will take still more steps to protect themselves. With appropriate
liquidity risk requirements, no panicky flights that threaten solvent institutions will occur,
but market discipline will matter. What’s more, big banks will either cure themselves
quickly or shrink fast. We can’t think of a quicker way to constrain too-big-to-fail banks.
Regulators are all for “transparency” when it comes to banks, but it would do at least as
much good for the industry if the regulators tried a bit of transparency on their own..