How Will Stress-Test Results Play?

Q&A: Industry Experts Assess Impact on Broader Sector, Economy
How Will Stress-Test Results Play?
Federal regulators on Friday began informing the 19 largest financial institutions on how they performed in stress tests they underwent over the past month to appraise their financial fitness. Initially, regulators provided the banks with details on how the assessments were made, and privately revealed preliminary results. Regulators will make some of the results public on May 4. The findings will include a capital recovery plan for banks that are found lacking capital should the economic downturn accelerate.

As regulators prepared to disclose the initial results (Stress Test White Paper Issued by Federal Reserve Board), the Information Security Media Group publisher of and asked two industry experts to assess how the stress tests results on these 19 big banks will affect the rest of the industry and the economic recovery. Managing Editor Linda McGlasson interviewed Peter Vinella, head of the financial services sector of LECG, a capital markets and risk management consulting company, and William Isaac, chairman of LECG's global financial services group and former chairman of the Federal Deposit Insurance Corp. Isaac headed the FDIC during the banking crisis of the 1980s, overseeing the takeover of the nation's seventh largest bank, Continental Illinois Bank, the biggest bank failure until 2008.

In the interview, Vinella and Isaac observed:

  • The banking industry has faced the biggest stress test of all, and failed it completely, during last September's financial crisis,
  • Weaker banks will face increased pressure on funding and may be forced to sell assets or take on more taxpayer money, and
  • The "real" banking regulators FDIC, Federal Reserve Bank and Office of the Comptroller of the Currency need to take back the process and de-politicize regulatory procedures, otherwise the ensuing outcome may drag out the economic recovery for a much longer time.

Linda McGlasson: What happens if all of the 19 banks pass the stress tests?

Peter Vinella: Markets have the old adage, "Sell on rumor, buy on the facts." The question is how factual will these results be? I think that one of the points to consider is equity investors are considering future earnings for these banks. Even if all the banks come up with healthy balance sheets, they won't regain the earnings they had back in 2005.

Banks and financial institutions in general will have problems generating revenue because the areas where they were generating massive revenue in the past four or five years is gone. There is not going be as much mortgage origination or all the fees associated with that, such as the servicing fees and other fees. Commercial loan business will be down. We're in a down cycle, businesses are failing, investment banking fees, and proprietary trading fees are down.

Even if everything was okay on the balance sheet and they passed their stress tests, the equity investors will have to ask will the banks have the same amount of earnings from 2005? Now, on the other hand, if a number of banks don't pass the test, there will be a significant downside and added pressure because then they will have to sell assets and won't be as near as strong as before.

The chance of the markets rallying if all the banks pass is not as high as the chances of if a large portion of these banks fail the stress test that the market will slump on talk of nationalization and equity investors again will fill in with the rumor. This may be one of the reasons the feds are going about it the way they are, cautiously releasing information on the tests.

William Isaac: We need to define "pass." I assume all of them will easily pass the best case and most likely case scenarios, and I don't think that will surprise anyone. The question is how negative is the worst-case scenario and do any flunk that test. My guess is the market will be skeptical if all of the institutions pass that test. If the results are made public, I believe the weaker banks will face increased pressure on their funding and might be under duress to take more taxpayer capital.

McGlasson: Is the public disclosure of these stress tests going to make more problems?

Vinella: One of the problems the federal government had under Bush and under Clinton is they looked at the problem, they came up with a solution to the problem, and they announce it and then time passes. Then, they realize that may not have been the best way to go about solving the problem. I think with these stress tests, what they were really dealing with was really dealing with the confidence crisis last fall and winter when it looked like every single bank was going to fail.

I remember I was on the trading floor when Lehman went under and the calls were going around the street asking who's next? Morgan? BoA? Goldman? In relationship to that kind of panic, the government is taking these stress tests to just come out and say "okay, things are bad, but they're not horrific" isn't a bad idea. Another thing that the Fed was looking at was the transparency issue.

Part of the credit crisis was due to the lack of transparency. Where investors lost faith in the structured credit and the financial institutions that were standing behind as a guarantor,

So, the feds say if we give them transparency, then everything will be fine. But now, as consumer optimism has returned, they're now asking themselves, well, if we come out and say these banks are weak, will it put us back to last September?

Part of that is looking back and wishing they could take back what they said. But they will have to go forward and release the results of the tests.

McGlasson: What do you see as the impact on rest of financial services industry? Will there be a ripple effect to the rest of the institutions?

Isaac: I don't think very many people are concerned about the smaller institutions - for the most part they did not have a hand in creating today's problems and are not too affected by them. The problem bank list remains quite low (something like 225, at last report) and the failure rate remains quite low. Keep in mind that some 3,000 banks and thrifts failed in the period from 1980 through 1991, including many of the large regional banks (nine out of the 10 largest banks in Texas, for example). At the end of 1991, there were still about 1,500 banks on the problem list despite all of the failures. The impact of the results of the current stress test, if the results are made public, will be felt primarily by the weakest of the large banks.

Vinella: When the feds announced what banks would undergo these stress tests, it said these are the banks that are too big or important to fail, and the rest of you can fail. That actually had an impact on a lot of the smaller institutions that signaled to others in the markets that these guys are going to be in trouble.

As for their actual balance sheet health, they keep their CAMELS ratings (of overall bank condition) confidential, unless there is a real problem with the institution, or very heavy action by a regulator, it's not possible to see how well some of them are doing unless you look at their 10K statements.

I think the general feeling is across the board is banks, big or small, aren't out of the woods yet. Commercial real estate defaults are going up. Mortgage defaults are still up, consumer debt defaults will continue to rise with unemployment.

I don't think institutions are really lending, my experience is they're not, except in certain markets and certain sectors. A lot of them are just sitting on their capital, waiting out this credit cycle. If a large majority of the 19 banks fail their stress tests, I think the overall feeling will be pushed down to the other 8,000 banks. If the top 19 all pass, it doesn't mean a clean bill of health for the other 8,000. I think it will be viewed on a regional basis and the types of loans they've been giving out.

McGlasson: So what is the real stress test?

Vinella: I see last September as the financial services industry stress test, and the result is that the industry failed it, completely.

If you look at what happened starting in end of 2007, where a lot of the huge losses began in investment banks, risk management failed, and trillions of dollars of value was destroyed. I think to say that banks have undergone stress testing before this, is true, but nothing prepared them for last fall. Do I fault anyone? Nobody could have foreseen the interbank lending collapse, the integration of the bank lending among other banks was far beyond anyone's understanding.

McGlasson: What's behind the two-part announcement, first saying how they conducted it, then giving out the results, (and just how detailed are these results going to be?)

Isaac: I can't imagine why they announced publicly three months ago that they were going to conduct the stress tests, why they leaked a week or two ago that they were going to make the results public, why they decided to hype the interest in the disclosures by releasing the results two parts, or why they leaked that the president himself is overseeing the results and might even play some role in announcing the results. The people making these decisions clearly do not have experience in bank regulation or crisis management. Neither did Paulson nor Bush, who made colossal mistakes., just so it is clear I am not being partisan.

McGlasson: Should these stress tests be done differently because of the change in the way banking is done now?

Vinella: I think what the government could have done a stress test at the system level, not at the bank level, and seen what would happen if not just one bank failed, but several.

The stress testing they're doing now is somewhat different because they're looking at macro economic factors, but its not looking at the tightly integrated nature of the financial services industry and how tightly wound many institutions are to one or more of these big banking firms and dependent upon them. For example, if JP Morgan Chase goes under, it would take another 2000 banks with it, because it operates as an outsourcer for those banks' checking systems and wire systems.

The fact is there is a lot of plumbing underneath the floors between all of these institutions that are unseen and not taken into account. If it breaks down, it affects all of those who are receiving that water. It is more complicated and more complex and the regulators and regulations have not kept up with it, the lay people don't understand it, and the federal government has done a poor job of explaining it.

One of the other things that is an issue is banks do stress testing, and it is a relatively mechanical exercise. There needs to be the question about returns for the level of risks being taken. I would like to see not just pass or fail for these stress tests, but work it into their strategic risk business plans, something else that regulators look at.

If you look at the CAMELS ratings scale, it actually does have rating on strategic vision. My issues with stress tests are they need to have strategic business and system wide viewpoint.

McGlasson: Should some of these big banks be allowed to fail?

Isaac: The time to deal with any large banks that are not viable over the long haul is after we have gotten the financial system and the economy turned around. There will be plenty of time to wind down non-viable large firms.

Right now, we cannot stand any more instability of the sort brought about by the failures of WaMu, Lehman, Bear Stearns, Freddie and Fannie, etc. I am not a fan of merging large banks into other large banks and potentially creating even larger problems. The regulators and the healthy institutions will clean things up when better times return.

Vinella: This is a philosophical question and also an operations question. Part of the problem is the Jekyll-and-Hyde approach the federal government has taken when it comes to failures.

The comparison can be made between Bear Stearns and Lehman Brothers. One was restructured and then sold off; the other was allowed to fail. As far as the types of business the two did, they weren't much different, except that Bear Stearns had a very big correspondent clearing operations for the New York Stock Exchange. But other than that, the two businesses were very similar.

The question is in the minds of equity investors, is the government going to back it or not? They need to come up with a consistent defined policy, and do it, and stick to it. People can argue that it's the wrong thing to do, but it needs to be consistent.

But this Jekyll-and-Hyde thing has been a hindrance, there is a lot of private equity money out there waiting on the sidelines to buy up banks or bank holding companies, but they're unsure of which way the government will decide.

Until the last TARP announcement, when the federal government said it would not be a third party buyer of the assets, but instead would be bidding along side the private equity firms, that made it clear where they stood.

McGlasson: Do regulators need to put their foot down and take back the process?

Isaac: I hope the regulators have the courage and strength to take back the process, and I hope the Treasury and the White House will have the wisdom to get out of bank supervision and give it back to the professional bank regulators who are by law supposed to be independent. Treasury, the White House, and the Congress are so involved primarily because massive amounts of taxpayer funding have been put into the financial system.

I understand completely the public backlash and the desire of politicians to get cover by appearing to be working hard on solving the problems and by bashing the banks and their management. It is just incredibly unfortunate that Paulson asked for the taxpayer funds last fall and the Congress complied without hearings, debate, discussion, amendments, or establishing proper oversight. I believe we could have done without the taxpayer funds last fall and I was quite vocal about it at the time.

McGlasson: What do you see coming next for the industry as it grapples with the impact of the financial crisis and tries to move toward recovery?

Vinella: Over 60 percent of the lending in 2006 and 2007 was through securitization that is virtually gone. So even if the banks were lending at the same levels of 2006, less than half of the capital would be available.

Some people in Congress have gotten this fact about lending. (Federal Reserve Chairman Ben) Bernanke certainly has grasped this fact. So we're a long way away from securitization coming back. And, another fact is banks are still deleveraging, and as long as they are deleveraging, they won't be lending. I think the banks that are saying they are lending are doing it for the public relations alone, than the fact that capital is going out the door for loans. I've seen businesses that went through a full financial audit in November and were out of business in January just because their credit lines were cut.

I am not blaming the banks for this - we are in a down credit cycle now. We had historically low corporate defaults, under 2 percent for several years. We're now into the fives, sevens and eight percent default rates. It is part of a cycle that happens to be coming at a very bad time. Banks understand that the reason they fail is lack of liquidity. So they will sit on their capital until the time comes when they don't mind not getting a return on their capital instead of being caught with their pants down if they need that capital.

If the banks continue to post good earnings reports over the next few quarters, their success will become self fulfilling. The economy goes up because people think positively, and you need to lend money and people will use that money to build future value.

McGlasson: The no-win situation that the government has placed itself in with these public stress tests, is there a way out of this labyrinth or will someone be sacrificed?

Isaac: They have put themselves between a rock and a hard place. I don't see any good scenario here, but the best one is to simply state that everyone is fine under the best case and most likely case scenarios and indicate that a very small number might need more capital in the worst case scenario and then indicate that the government will work with those institutions should they need help in a worst-case environment - end of press conference, say no more.

The potential impact disclosure of these results will have: on industry, on markets, on the banks themselves, and the overall recovery? Just announcing the process and letting speculation run wild for three months has been destabilizing. If they do what I suggest in the immediately preceding answer, they will limit but not eliminate further damage.

The regulatory process has been politicized in a way that has never before occurred. If we do not return the regulation of banks as quickly as possible to the professional regulators at the OCC, Fed and FDIC the outcome will be ugly.

McGlasson: How ugly are we talking about?

Isaac: We will slow the economic recovery and subject the banking system to unhealthy political pressures for years if not decades to come. I am utterly convinced that the financial crisis and economic problems are much worse than they needed to be because the politicians have been directing the action over the past year instead of the independent banking agencies who have a great deal of experience with crisis management and the subtleties of bank supervision.

About the Author

Linda McGlasson

Linda McGlasson

Managing Editor

Linda McGlasson is a seasoned writer and editor with 20 years of experience in writing for corporations, business publications and newspapers. She has worked in the Financial Services industry for more than 12 years. Most recently Linda headed information security awareness and training and the Computer Incident Response Team for Securities Industry Automation Corporation (SIAC), a subsidiary of the NYSE Group (NYX). As part of her role she developed infosec policy, developed new awareness testing and led the company's incident response team. In the last two years she's been involved with the Financial Services Information Sharing Analysis Center (FS-ISAC), editing its quarterly member newsletter and identifying speakers for member meetings.

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