Pressure's on: will tougher stress tests offer an accurate picture of banks' cash reserves

Ten of the top US banks require a combined $74.6bn of extra
funds to bring their capital reserves to a level deemed acceptable, under stress
tests concluded in May by the Treasury and Federal Reserve.

We know that because, from the outset, the US authorities have been
transparent about the methodology and objectives of this exercise to measure the
health of the banks and find out which might require more cash reserves in the
event of even more economic catastrophe. Candour is cleansing and with the
public release of the results of these stress test, fears of nationalisation or
failure have largely disappeared.

But what do we know about the British banks’ ability to withstand more severe
shocks to the system? Not a lot, if we go by what the Financial Services
Authority is prepared to tell us.

Health check
With Royal Bank of Scotland and Lloyds Banking Group under state control, it
might be considered logical, or at least a courtesy, to inform taxpayers of the
state of their new liabilities.

“Stress testing is a normal part of the supervision of firms,” says a FSA
spokeswoman. “We have talked about putting larger firms through heightened
supervision and we are looking more intensively at how they are managing their
risks.” In short, the regulator rules out publishing the results of its own
stress tests on the grounds that this could be “damaging to market stability”
and release commercially sensitive data.

The FSA’s concern over market stability might raise speculation over the
banks’ solvency, had they not been so forthcoming with their tales of
mismanagement and excessive risk-taking. In fact, Barclays has been given a
clean bill of health by the FSA and says its cash position and resources meet
the regulator’s capital requirements.

The aim of the stress tests was to find out which banks might require more
cash reserves in the event of the economic outlook worsening and to prompt the
weaker ones to raise capital. By applying criteria of a major negative and
unexpected impact to banks’ balance sheets, the US banks that failed the test
will have to raise capital or sell off assets to boost their capital position.
“Our hope… is that banks are going to be able to get back to the business of
banking,” says Treasury secretary Timothy Geithner.

But a study carried out by New York University says the doomsday scenario
that the banks’ books have been subjected to is actually no worse than the
current economic situation. “The stress test results will not be credibly
interpreted as a sign of bank health,” it says. Depending on what banana skins
await the global economy, it may transpire that the stress tests have been
successful as a PR exercise, with the jury still out on whether they will make
weak banks any stronger.