Why the 2009 US stress tests worked

This blog has frequently observed that the reason why the US stress tests worked in 2009 was because the 19 banks that were tested were then backed by a pledge to inject as much capital as necessary by the US government.

Today, a Wall Street Journal article independently confirmed that it was the pledge to inject capital by the US that accounts for why the 2009 US stress tests were successful.

On Feb. 10, 2009, Treasury Secretary Timothy Geithner outlined the new administration's plan to subject 19 large U.S. banks to government-administered "stress tests" to see how much more capital they would need to fill the hole in the event of another severe recession or collapse of housing prices. 

The speech flopped. The Dow Jones Industrial Average lost nearly 400 points while he was speaking. The very phrase "stress test," though common in financial circles, conjured up images of Citigroup Inc. collapsing on a treadmill. The left derided stress tests as a poor substitute for nationalizing banks, the right as a precursor to nationalization, financial pundits as a whitewash or worse. 

Yet by most retrospective accounts, the stress tests worked better than hoped. Despite sniping that the worst-case scenario used wasn't bad enough, the tests were credible enough to help markets distinguish between weak and strong U.S. banks and to bolster investor confidence in the stability of the U.S. banking system. 

"The U.S. stress tests were a key driver of the recovery from the financial crisis both because they made bank balance sheets more transparent but also because they forced banks to recapitalize, with some government help," says Frederic Mishkin, a Columbia Graduate School of Business economist and former Federal Reserve governor... 

When results were disclosed in May 2009, after much speculation and back and forth between banks and regulators, 10 banks were told to raise $75 billion in new capital. The U.S. government had said taxpayers would provide capital from the Troubled Asset Relief Program unless banks could raise money from markets; all but one raised the money privately. 

Regular stress tests are now among the tools the Federal Reserve and other bank regulators are using to try to prevent a repeat of the financial crisis...

"The U.S. stress tests succeeded because they forced banks to raise a lot of capital," says Anil Kashyap, an economist at the University of Chicago Booth School of Business, noting the U.S. government's willingness to provide a "backstop"' source of capital if needed. 

"The last European test failed because it did not mandate recapitalization. Whether this one succeeds will hinge on whether they are honest about the capital shortages and include a backstop that will force the banks to raise capital one way or another."