How to Interpret the Stress Tests

The government is officially releasing results of the “stress tests” on the 19 largest American banking firms today. These tests are designed to determine which banks can hold up during a recession, and which banks need to raise more money–as determined by the government. The test results will come with directives for the firms, all of whom have received some form of bailout or assistance.

For instance, Bank of American found out earlier this week that it needs to raise $34 billion in capital over the next six months or face seizure by the FDIC–essentially nationalization. This ultimatum for BoA is, as Megan McArdle puts it, “above ‘unreachabily high'” and presents a problem for the mega financial institution. They can raise capital by getting loans from the private sector, convinving the government to give them more money, or selling assets. It has been suggested that they might sell their First Republic Bank unit and China Construction Bank, the second largest Chinese lender.

Bank of America claims it does not need the capital to continue surviving in this recession. Recently deposed Chairman, but still CEO Ken Lewis said on April 20 that “we absolutely don’t think we need additional capital,” but added that credit conditions remained weak, especially in credit cards.

So what should we read into these test results? Essentially, the stress tests and accompanying demands on banks reveal what the government is thinking about the economic situation, how deep the crisis, and where we are going. Douglas Elliott at Brookings sums it up nicely:

“These [19 largest] firms dominate the U.S. banking system, holding over two-thirds of the system’s assets among them. Good or bad news about them has profound implications for the overall economy, because the credit crunch created by the banking crisis is a major contributor to the severity and length of this recession… the results will give us a real sense of the thinking of the regulators about the financial state of the banks, based on a detailed, comprehensive analysis. Unfortunately, this view may be muddied a bit by political constraints.”

What should you be looking for in today’s stress test announcements? First, how many banks the government deems in need of help. If it is just the handful we have heard of that may increase the likelihood that the government will eventually take them in whole, break them up, and sell them back to the private sector piecemeal. Second, look for the aggregate capital shortfall the government gives. The total capital needed to be raised according to the government is a key indicator for how bad they feel the economy is going to get before it gets better. The small the number, the sooner the estimated end of this recession. Third, look for potential regulatory changes or demands. The results of the stress tests create a platform for the Treasury Department to work from in figuring out how best it wants to take the reigns (or not) of Wall Street.