June 04, 2009

The markets greeted the much-discussed banking stress tests with open arms. In fact investors actually cheered the news that banks needed to raise only an additional $75 billion. Gulp.

But a closer look at the stress tests raises a number of questions about their quality. For starters, the government completed these exams awfully quickly -- it took the feds just a few short months to evaluate the balance sheets of these financial institutions. Consider this: A private independent auditor, such as KPMG or Ernst & Young, would take at least a couple of months with an army of accountants to audit just one bank. The government, with far fewer resources, completed the stress tests on 19 of the country's largest banks in the same amount of time. Hardly a thorough audit.

Also, once banks were shown some of the initial results (a common practice among regulators and the banks before results are made public), banks started lobbying the feds to change the results, claiming the government's capital reserve requirements were too extreme. According to The Wall Street Journal, the government initially wanted to require Bank of America to raise an additional billion; Citigroup, .5 billion; Wells Fargo, .3 billion; and Fifth Third Bancorp, .6 billion. The final numbers turned out to be much lower: BofA, .9 billion; Citigroup, .5 billion; Wells Fargo, .7 billion; and Fifth Third, .1 billion.

It's almost akin to arguing with your cardiologist about your EKG results or contesting your high school Chemistry grade because you thought the questions were too hard. Essentially the banks didn't like the way they were graded. As a result, the government graded the banks using the "Tier 1 Common Capital" ratio, which is much less stringent than the "Tangible Common Equity" ratio that many outsiders expected the government to use. If the latter ratio had been used, the 19 banks could have been required to raise an additional billion collectively.

So although investors cheered the stress tests' results, I'm wondering if the standards were strict enough. Granted, the feds needed to walk a fine line: If the results showed that the banks were too weak, the markets would have been spooked; if the tests were too lenient, the results wouldn't have been believable. In the end it seems we received watered-down stress tests that may cause a lot of stress down the road, especially if banks aren't able to weather further economic storms that may yet come during this current economic slump.

ABOUT THE AUTHOR
Greg MacSweeney is editorial director of InformationWeek Financial Services, whose brands include Wall Street & Technology, Bank Systems & Technology, Advanced Trading, and Insurance & Technology.