Bank stress tests are about to get serious

The coronavirus crisis has thrust the world’s financial markets into extreme uncertainty. The wild swings in asset prices, along with the sudden and pervasive demand for cash, reflect people’s struggles to understand how bad things can get and how damaging the losses will ultimately be.
Back in 2009, amid a similarly frightening crisis, the US discovered a novel way to restore clarity and confidence: government-run stress tests that showed how much the country’s largest financial institutions stood to lose, and ensured they would get the resources they needed. It’s a tool that the Trump administration and Congress should be preparing to apply again. The Federal Reserve conducts stress tests of the country’s largest banks every year. It devises worst-case scenarios consisting of deep recessions and market routs, tallies the hypothetical losses and decides whether the banks are adequately prepared. But the scenarios for the latest round, already underway, were designed before the pandemic hit. Worse, the exercise has devolved into a formality that doesn’t reflect what happens in a real crisis, and that banks tend to pass too easily.
The 2009 version was very different. For one, the sheer severity of the ongoing global financial crisis dictated scenarios that bore some semblance to reality. Also, the government promised to provide capital if banks’ own loss-absorbing capacity fell short. By drawing a line under losses and providing a credible backstop to the system, the effort helped banks raise funds from private investors and proved to be a turning point.
There’s ample reason to believe that the coronavirus pandemic will merit a no less robust response. Perhaps the Fed’s extraordinary measures and a well-targeted fiscal stimulus will calm markets and replace the income lost to lockdowns aimed at stopping Covid-19’s spread. More likely, this episode will deliver one of the biggest negative shocks the US economy has ever experienced, precipitating widespread losses as millions default on credit cards, mortgages, corporate debt and on collateral demands in derivatives and other markets. In one sign of investors’ concerns, the KBW index of US bank stocks has declined almost twice as much as the broader S&P 500 Index since the beginning of this year. The sooner the losses can be defined and recognised, the sooner the healing can start.
How, then, to proceed? First, administration officials and lawmakers should make plans to set aside funds and authorise the Treasury Department to inject capital into any financial companies found lacking. Yes, this entails explicitly allowing government bailouts. And yes, to some extent this may involve rescuing institutions that acted irresponsibly by, for example, fuelling a boom in corporate debt that has left many businesses unduly vulnerable to a downturn, and by failing to maintain enough equity capital to withstand the inevitable consequences. Lessons must be learned and acted upon. But for now, the government must stand ready to ensure that financial instability doesn’t deepen and accelerate the economic crisis. The Fed can’t require a credible reckoning unless it knows where the capital, if needed, will come from.
Second, the Fed should forbid banks to pay dividends or buy back stock — actions that deplete capital — and start building scenarios for a special round of stress tests designed to shed light on potential losses. The exercise should cover the country’s largest banks and any other relevant financial institutions, including the clearing houses that play a central role in derivatives markets. And it should be as realistic as possible, taking into account both direct losses and the indirect effects of distress among counterparties. Allowing banks to hide problems — for example, by postponing or tweaking accounting rules — will only undermine confidence and prolong the crisis.
—Bloomberg