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Will Bank Stress Tests Be “Put on a Curve?”

Posted by Larry Doyle on April 22, 2009 9:10 AM |

Will the soon to be released Bank Stress Tests provide real clarity on the health of our banking industry or will the tests be “curved?” Meredith Whitney, highly regarded bank analyst, has indicated that the tests will provide plenty of wiggle room for the banks. Just yesterday Secretary Geithner “goosed” the market by indicating the majority of banks have sufficient capital. To what degree can we trust what Turbo-Tim is telling us?

Mohamed El-Erian, CEO of PIMCO (Pacific Investment Management Company) provides a blueprint for an honest review of the Stress Tests. Mr. El-Erian highlights the following in a Financial Times article:

First, transparency is key. Whether the government likes it or not, hundreds of analysts around the world will reverse engineer the stress tests. The government would be well advised to assist the process through clarity. Obfuscation would result in damaging market noise and further derail the real economy. At the minimum, policymakers need to provide credible details on the methodology, the underlying assumptions and scenario analyses.

To this point, neither the banks nor the government have provided real transparency. What are we to expect when Congress pressures the FASB to relax mark-to-market accounting thus forever clouding real transparency?

Second, the results of the stress tests must be part of a comprehensive, forward-looking package to resolve problems at banks. Out-performing banks should be provided with exit mechanisms from the exceptional government support that they have been receiving and, presumably, no longer need. At the other end, there must be clarity as to how capital-deficient banks that no longer have access to private capital will be handled.

Geithner has already told us he will be focused more on the industry as a whole than the capital positions of individual banks. Geithner indicated yesterday that banks in need of capital would have a variety of methods to raise that capital. I view Geithner’s comments here as similar to the rope-a-dope approach used by prizefighter Muhammad Ali. What’s that? Let the opposition – or in this case, investors and analysts – wear themselves out looking for the truth.

Third, the banks’ recovery and rehabilitation efforts must be co-ordinated closely with other efforts to put the banking system back on a viable road. In particular, they need to work together with the implementation of initiatives aimed at lowering funding costs (such as federally-guaranteed borrowings and Federal Reserve facilities), and facilitating the removal of the overhang of toxic assets. This will require a level of co-operation among US agencies that, historically, has not come easily or effectively.

Why doesn’t El-Erian merely say that the Games of Chance: TALF, PPIP, TARP, FDIC, FASB need to continue? Make no mistake, PIMCO, one of the largest money managers in the business, is heavily involved across the spectrum of these programs.

Fourth, the government should arrest and counter the recent erosion in key parameters of the market system. Specifically, it must work hard to resist the temptation to override contracts, to undermine the sanctity of the capital structure and to treat differently stakeholders with similar legal rights. Indeed, seemingly attractive and politically expedient financial engineering, such as that used in the third Citigroup bail-out, risks undermining long-standing principles that have served the US well for years.

El-Erian is lobbying here for the protection of bondholders versus government interests. Additionally, he is lobbying on behalf of investors so that contracts aren’t rewritten (e.g. principal reduction via mortgage cram-downs).

Finally, the US must never lose sight of the international dimensions of its policies. Its response must be consistent with efforts to upgrade a deeply challenged infrastructure for cross-border harmonisation of regulation and bank capital. The aim is to ensure a degree of global consistency that clarifies accountability and responsibility.

El-Erian is playing into the global theme that emanated from the G-20 summit held earlier this month in London.

In summary, if I am an investor I hope Geithner does not “curve” the tests. If I am a bank executive, I am pressing hard for a “curve.” El-Erian provides a solid checklist to measure the integrity of the grades.


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