Financial markets are awaiting Treasury’s two-part communication on large bank “stress test” results with equal measures of curiosity and dread.  On April 24th, apparently, the Treasury plans to provide a written description of the stress tests’ methodology; on May 4th, at some level of abstraction, the results of that methodology for the largest 19 U.S. banks will be revealed.

Market observers and participants have heaped criticism on the stress tests.  Indeed, it is difficult to find any especially vocal supporters of the concept, or at least the concept as executed to date.  The critics fall into two categories:  those that question the substantive merits of the tests; and those that question how the results of the tests can possibly be disclosed without further and needlessly de-stabilizing the banking system. 

Both sets of critics are wrong. 

Although the undertaking surely has flaws, even a flawed effort has the potential to remedy the most profound strategic errors of the haphazard bank recapitalization effort.  The challenge for the Administration is to communicate the tests’ results in a way that captures that potential for redemption, instead of muddying the waters further.

Redemption for TARP’s original sin

Although the Administration does not describe the stress tests in this way, the initiative has the potential to help undo the most profoundly damaging strategic errors of the original Paulson capital purchase plan.

The original TARP capital effort -- the capital infusions first “forced” on the largest nine banks last fall -- failed because of a misguided desire to treat all banks the same way.  Every large bank, whether seemingly sound or obviously distressed, took the same proportion of taxpayer capital, under the same terms, and at the same pricing.  And, apparently out of a desire to obscure the otherwise obvious troubles of weaker banks, no capital recipients were forced to be more transparent about the depth of their potential credit deterioration.

This willful abdication of the basic principles of risk-based pricing led to the worst of all possible outcomes. 

The strongest banks haven’t much changed their approach to doing business, because capital wasn’t a binding constraint in making their lending decisions in the first place.  The weakest banks, which are still by and large led by the same management teams as before, did not through the introduction of taxpayer capital magically transform into good credit risk managers.  And, because those weak banks’ loan portfolios are precisely as opaque and risky as they were beforehand, private capital is no more likely to invest in weak banks now as before the taxpayer was forced to invest in them.

So nothing has really changed:  stronger banks remain strong, but haven’t changed their behavior; weaker banks are still struggling, and have no obvious prospects for private market relief.  But hundreds of billions of dollars in taxpayer money has been invested, and political goodwill has gone up in smoke.

The stress tests won’t be perfect (no forward-looking exercise ever can be), but they absolutely should help solve this fundamental problem.  By appropriately calibrating capital infusions to capital need, taxpayer capital isn’t unproductively deployed into strong institutions that don’t need it.  And, by adding some transparency to otherwise opaque bank portfolios, the prospects of private capital investment -- even into weaker institutions -- become more realistic.

Substantive concerns are real, but not fatal

We should not dismiss out of hand, of course, the range of substantive objections to the tests.  They come in three basic varieties:  (1) the stress tests aren’t sufficiently conservative; (2) the stress tests are analytically doomed to fail because the assembled regulatory teams have inadequate capabilities, time, or bandwidth; and (3) the stress tests are redundant.

The first point certainly has merit.  The stress tests model capital positions under two scenarios -- a base case and a more adverse case -- of GDP growth, unemployment rates, and home price appreciation.  Given that the “adverse” case seems to assume economic deterioration (e.g. average 2010 unemployment of 10.3%) that looks a lot like buy-side base case assumptions today, it is a fair criticism that the “stress” in the stress tests isn’t stressful enough.  One would hope, however, Treasury’s explanation of the tests’ methodology on April 24 will at least point towards how investors and taxpayers should think about the sensitivity of capital levels to these critical assumptions.

The second objection is that the team supervising the initiative (if persistent rumors are to be believed, mostly Fed staff from outside day-to-day supervisory functions) is not up to the task.  This argument might also have merit, but it is not clear what policy-makers should do as a result.  After all, our regulatory bandwidth is the victim of decades of mismanagement:  regulators are famously overburdened; dramatically ill-compensated versus their charges; and fragmented across an array of competing regulatory bodies.  The Administration appears serious about remedying this set of problems over the long term.  Sadly, taxpayers have not been asked to backstop the financial system over the long term; they have already been asked for staggering levels of support now.

The third objection -- the redundancy argument -- was perhaps most famously and colorfully described by Wells Fargo Chairman Richard Kovacevich in a speech at Stanford in mid-March.  “We do stress tests all the time on all of our portfolios,” Mr. Kovacevich pointed out. “We share those stress tests with our regulators. It is absolutely asinine that somebody would announce we’re going to do stress tests for banks and we’ll give you the answer in 12 weeks.” 

It is certainly true that stress testing has been part of the overall regulatory milieu for a decade; and it is certainly true that most banks conduct stress tests on their capital positions. 

It’s just that, in general, they don’t appear particularly good at it. 

Indeed, FDIC data demonstrate that over the past four years -- despite the absolute inevitability of an eventual credit downturn (they’re called credit cycles for a reason) -- banks as a whole allowed their tier-1 and tangible common equity ratios to decline steadily.  In other words, as the credit environment became increasingly volatile and risky, banks responded by reducing their buffers to that volatility and risk.

Of course, not all bank management teams were uniformly inept in this regard.  This is, presumably, what makes the stress tests frustrating for institutions that were relatively well managed.  But that is more reason, not less, to support the notion of stress testing:  Stress tests debunk the unproductive fiction that all banks are similarly situated.

How to talk about stress test results

That brings us to the tactical question of how to communicate stress test results without inadvertently setting off another round of panic across the financial markets.  Here are the five core themes that the Treasury must take care to underscore.

First, depositors are safe.  Even if a handful of large banks appear undercapitalized, the FDIC is fully capable of and committed to protecting the value of FDIC-insured deposits. 

Second, banks are welcome to raise capital in the private markets to address identified shortfalls.  But those efforts almost certainly will fail, so the Congress and taxpayers should be prepared for the need for government capital investment, and also be prepared to see the government’s preferred equity stakes converted into common shares.

Third, banks that are under-capitalized got that way, and stayed that way, at least in part through severe mismanagement.  As the new, largest shareholder in such banks, the taxpayer has a right to find better managers.  But taxpayers should realize that top talent typically does not work for free.  And Congress should realize that futile post-hoc saber-rattling (like the House’s AIG-inspired TARP bonus bill) is decidedly unproductive.

Fourth, the Administration remains committed to private ownership of banks.  That means we should seek to divest the taxpayer’s equity positions as soon as practical.  It also means that banks with a capital surplus versus the stress test results should be free to return taxpayer capital, without further onerous hurdles.

Fifth, banks and their primary regulators should have been using stress test methodologies to calibrate their economic capital requirements all along.  The fact that they had so profoundly underestimated downside scenarios is what makes government intervention necessary now.  Crafting a more robust regulatory architecture is a necessary part of ensuring we don’t find ourselves in the same position again during the next credit cycle.

The stress tests are a big step in the right direction; the Treasury should take advantage.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.