Myths and Fallacies Watch: Stress Tests

This is the first of a series of posts that looks at Myths and Fallacies related to financial regulation.  It will focus on stress tests given their recent prominence.   In Ireland, the stress tests were suppose to reveal all the problems in its banking system.  Next up was the announcement by European financial regulators of new, tougher stress tests.

Myth and Fallacy:  Stress tests help to restore confidence in the capital markets.

Fact:  The stress test that the global regulatory community points to as proving that stress tests restore confidence in the capital markets was the first stress test run in the US in 2009.

What is conveniently ignored was the announcement at the time the results were released that the US would guarantee the solvency of the 19 banks tested.  The capital markets reacted to the guarantee and not to the results of the stress tests.

Myth and Fallacy:  There is enough information provided as a result of the stress tests so that investors do not expect to be bailed out for solvency related losses incurred by the banks.

Fact:  The first stress test explicitly guaranteed that unsecured debt and equity holders would not lose money as a result of insolvency.  Subsequent stress tests implicitly reaffirmed the government guarantee.

After all, nobody expects investors to be willing to take solvency related losses on an investment in a bank after the government has declared that it has passed a stress test showing the bank to be solvent.

Myth and Fallacy:  Stress tests show that financial regulators are up to the task of monitoring and managing risk in the financial system.

Fact:  The first round of stress tests in Europe was discredited in a few months when banks that passed the stress test in Ireland needed to be bailed out.

Myth and Fallacy:  Disclosure of current asset and liability-level data is not needed as the results of the stress test substitute for investors being able to do their own analysis and risk assessment.

Fact:  As discussed above, the stress tests implicitly reaffirm the government guarantee of bank solvency.

The stress tests do show that the financial regulators have a monopoly on all the useful, relevant information on financial institutions.  However, as the Governor of the Irish Central Bank pointed out, the failure to provide all the useful, relevant information to the market so it can confirm the results of the tests for itself sends the message that the financial regulators have something to hide.

Until all the useful, relevant information is disclosed to the market, taxpayers are trapped to support the implicit solvency guarantee provided with each round of stress tests.