Stressed About the Stress Tests

Wells Fargo, May 4, 2009 

The Obama administration is sending mixed messages about bad banks.

By James Kwak 

One of my backgrounds is in marketing. A key goal in marketing is to identify your one main message and communicate it as clearly and consistently as possible. The Obama team did this masterfully during the presidential campaign. Unfortunately, it is having less success doing this when it comes to the crisis in the financial sector.

The core problem is that people lack confidence in the long-term strength of some of the largest U.S. banks. The stress tests whose results will be announced on Thursday, May 7, (and are leaking out daily) make sense as a regulatory measure: By forecasting how banks will be affected by a severe recession, the tests should indicate which banks are healthy, which need more capital, and which (if any) are hopelessly insolvent and should be closed. If people think that the tests are sufficiently rigorous, then they should have confidence in the banks that survive.

However, administration officials are torn between two alternative messages. On one hand, they fear that revealing negative information about major banks could cause a panic, so the first message is that the financial system is doing just fine, thank you. Treasury Secretary Timothy Geithner said on April 21, "the vast majority of banks have more capital than they need to be considered well capitalized by their regulators." A New York Times article in April was even blunter: "Regulators say all 19 banks undergoing the exams will pass them."

On the other hand, no one will believe the results of a test that all banks are able to pass. So the second message is that the administration is taking the problems in the financial sector seriously and not coddling the banks.

The result is a message that goes something like this: "Some banks have health issues, but those issues can be resolved through proper diet and exercise" (additional capital). This is the message that is leaking out with the test results (Bank of America needs $34 billion, Wells Fargo $15 billion, Citigroup $10 billion). Ideally, the numbers should be big enough to be credible, but small enough to avoid panic.

The positive reaction of bank stock prices to these leaks implies that the administration has achieved its first objective of not causing a panic. However, achieving the second objective of showing seriousness will be more difficult because ultimately it requires actually fixing the banks' balance sheet problems. On this front, the outcome is less clear.

First, the results of the stress tests are being negotiated between the banks and the government. One theme of the financial crisis is that as the banks have become more dependent on the government, the government has also become more dependent on the banks -- to not blow up and damage the economy. If the final capital requirements are the product of negotiation, rather than rigorous, objective analysis, they are less likely to be believed.

Second, the banks will have the option of meeting their capital shortfalls simply by converting the government's existing preferred stock investments into common stock -- an accounting trick that provides no new cash to the bank.

Ultimately, the success of the tests will depend on how much information the administration provides. If the results enable investors to make independent judgments about banks' health and the banks are able to raise the required capital from the private sector, then that will go a long way toward restoring confidence in the system. If the stress tests remain a black box and we simply have to trust that they accurately reflect the banks' condition, then we will go right back to where we started. Undoubtedly, some of the brightest minds in Washington are struggling with that marketing question right now.

James Kwak is a student at Yale Law School and coauthor of the economics blog The Baseline Scenario.

Photo: Justin Sullivan/Getty Images