Fed’s stress-test revamp brings good and bad news

November 28, 2011

By Antony Currie
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

There’s good and bad news in the U.S. Federal Reserve’s decision to expand the scope of its annual stress tests of the nation’s top banks. Given the deteriorating economic picture, submitting the 31 largest lenders to even more awful scenarios than in the previous two years makes sense. So does putting the European exposures of the top six banks under the microscope. But the Fed’s latest move will leave many on both sides of the Atlantic unhappy.

Start with the U.S. angle. The Fed is expanding its stress test beyond the 19 largest banks to include another 12 with $50 billion of assets or more. Considering that several mid-sized banks landed in trouble in the last crisis, bringing them into the fold is overdue.

The Fed is making all 31 banks run some pretty depressing numbers through their models: an 8 percent shrinkage in GDP, the Dow Jones Industrial Average halving to 5,700 points by the middle of next year, and an unemployment rate rising above 13 percent by 2013. The six largest banks must demonstrate they can also withstand a euro zone crash that whacks European governments and financial institutions.

The test probably means few, if any, banks will be allowed to raise dividends or buy back more stock next year. But it’s the Fed’s job to ensure they’re not squandering capital. And the tests ought to make it much harder to cast aspersions on the creditworthiness of any bank that passes.

But the process will take time. Banks have until January to file their results, and based on this year’s exercise, results aren’t likely to be known until April. By that time, the U.S. and European meltdowns that the Fed’s scenarios imagine could be underway. Pity the bank that is told to raise capital in such an environment.

Meanwhile, Europe looks set to suffer even more. By protecting its own, the Fed may inadvertently spark a bout of enforced financial nationalism. U.S. banks are already reining in their exposure to the euro zone. But the mere fact that the Fed is increasing scrutiny of their exposures could accelerate the withdrawal. That increases the risk that the stress scenario becomes reality.

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