Stress Tests of the Other Kind

Mention stress-tests to healthcare workers..and it can only mean one thing –  jogging patients on the treadmill to ascertain their cardiovascular fitness. But in the world of finance and global economics, this term takes a different meaning.

Recently, banks in Europe were subject to stress-testing to ascertain their ‘fitness’ to carry on their business. In banking, this is not a new term and came into prominence in the US last year when the major banks were put to the test by forward-looking economic assessments of themselves. In essence, projections are done into the future (usually 2 years) to see, in the event of a worse-scene scenario, whether the banks will have enough money to survive.

Take the case of the stress tests conducted on 19 of the top banks in the US last year. The projected worse-scene scenario for 2009 & 2010 was put in place: the economy was to shrink 3.3% in 2009, the unemployment at 8.9% and home-prices to drop 22%. Based on this scenario, 10 of the banks failed, some of which are household names (see diagram below).  They were required to raise their capital to maintain solvency.

In the case of Europe, stress-test results on 91 banks released on 23 July 2010  showed that 7 failed (5 of which were from Spain). The prescription? They were asked to raise new capital in order to meet the ‘normal’ values.

Critics of these tests say these tests are badly flawed. They allege the assumptions themselves should be given a failing grade, while others decry the influence of politicians who want to ensure the results are not too damaging to the nation. Others say the tests are not ‘stressful’ enough..its like a doctor trying to gauge the health of one’s heart by setting the treadmill at a leisurely pace!

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2 responses

  1. Great post! Philosophically I would suggest little to no government involvement in business. Let Adam Smith’s Invisible Hand take care of the weak banks. Unfortunately, with so much power resting in so few intitutions, I feel it is necessary to conduct some sort of stress test like this. Whether or not the above is the right test… I do not know. I would lean toward this being a politicians game.

  2. Stress tests are at best speculative. As can be seen, the worse-scene scenario of last year’s tests for 2010 has already been off target.
    The best thing to do is to leave the politicians out of the equation and allow fully-independent bodies to do what must be done.

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