How to Grade the Stress Tests and PPIP

May 4, 2009 4:15 PM

In school, usually one cannot postpone exams, and only real grubbers try to negotiate with their examining professors for better grades. In medicine, if one puts off one's diagnostic tests, problems usually get worse. Whichever analogy the Treasury tries to use for explaining their stress tests, the drawing out of the process and the release of the results can hardly be seen as good news or good policy.

The fact that by design the tests were to take several weeks, when ideally supervisors already had the data and just had to recalibrate the models, followed by six months for undercapitalized banks to fix their problems, only adds to the sense that this is all about forbearance. And as discussed in several posts on RealTime, as well as in my 2000 book, forbearance, keeping the banks open in hopes their balance sheets recover, is bad.

Still, the Treasury and Fed may be doing the best they can, given that Congress has explicitly told them it will not provide more money for bank "bailouts" now. And the results of the stress tests leaked so far, notably that Bank of America and Citigroup will be asked to raise $10 billion each in new capital, are tougher than the cynics expected. Will that be tough enough to put the banking problems behind us? Clearly, no one is panicking about the US banking system, or even about particular banks, which makes sense since the government has guaranteed so much of the system. But given those guarantees, and the slow enforcement of the stress tests, it would seem to be kicking the problem down the road, whatever the intentions.

How would we know if the stress tests are working, in the sense of being good policy leading to a good outcome? We have to consider them jointly with the Public-Private Investment Partnership (PPIP) put forward by Treasury Secretary Geithner, because the two programs are designed to work together in reducing the capital shortfalls of the major banks. The pressure from the stress tests is supposed to lead to greater willingness on the part of banks to sell their bad assets, and the sales of the bad assets are supposed to provide more private capital. I think this design is too clever by half , but we will soon find out. Here is what people should be looking for:

  • The combined amount of money going in to the toxic assets auctions and post-test capital injections—if it isn't in the (low) hundred billions total, it probably is not enough;
  • Where the money for the toxic asset purchases and the capital injections comes from—if it is new money from private sources outside the banking system either bidding or injecting, that's a good sign; if it is swaps of money between the banks buying each others' fire-sale assets or conversion of US government preferred to common equity (with no additional conditions), that's a bad sign;
  • The creation of a secondary market, meaning sales by the initial purchasers to other smaller investors, of the PPIP auctioned assets—if such a market does not arise, then the initial purchases are likely solely driven by the government guarantees, and there will be no real "price discovery" to guide supervisors; and,
  • The flow of credit from the top 19 banks going to new or smaller customers—if the banks continue to sit on their funds or, worse, just roll over and extend loans to current big borrowers, then they still do not have enough capital.

An additional vantage point from which to judge the entire exercise will be the reaction of international capital markets and other countries' bank supervisors. I do not expect the stress tests and PPIP to have a first-order effect on the value of the dollar, or US long-term interest rates, since the government guarantees prevent any panic for now. But if most other governments view the United States as being too wimpy on the banks, we can expect either legitimate grousing about the United States' subsidizing its banks unfairly for international competition, or more private capital flowing into bank stocks of countries where the situation is clearer. Of course, on these criteria, maybe we only need to worry about Canada, Spain, and Sweden being tough enough by comparison for the time being.

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Adam S. Posen Senior Research Staff

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