Yes, Banks Are Stressed. So What?

(MoneyWatch)  As the May 4 deadline for the results of banks' stress tests draws closer, the criticism is piling up.

"[Government officials] have gotten themselves in a pickle on this thing," one banking analyst told the Los Angeles Times this week in a statement characteristic of the criticism. "It's clear they didn't think through how this was going to play out."

Essentially, the critique is that rigid stress tests will stop industry goliaths such as Goldman Sachs, Morgan Stanley and Citigroup from engaging in any kind of meaningful lending activity, just as they were getting going again. That's because the banks will supposedly be so cautious about "passing" the stress tests that they'll stop lending money to each other for fear of exposing themselves to too much counterparty risk. Or so goes the argument.

While the government insists that the role of the tests is to impartially determine whether any banks will need additional capital over the next few years, the plan's detractors claim that by setting up such tests, the odds of further bailouts -- and possibly even nationalization -- will rise considerably due to the government "interference."
This week, regulators are rubbing salt into the wound by clashing with each other over how to disclose results from the stress tests of 19 U.S. banks. Most recently, Nobel Prize-winning economist Michael Spence said he doesn't expect every bank to pass the stress tests. "The data on lending and credit are not that encouraging," he told Bloomberg Monday.

Stressed out, but so what?
Ironically enough, the plan's problems stem from what the Obama administration touts as one of its selling points -- namely, the fact that all banks will pass the stress tests. If that happens, handing a seal of approval to both a reasonably creditworthy institution such as Morgan Stanley and a rather more dubious one such as GMAC could spark a credibility crisis over standards in the industry as a whole.

"There are plenty of ways to go wrong here," Wayne Abernathy, executive vice president of the American Bankers Association in Washington, told Bloomberg Monday. "It might have sounded good at the time, but now looking back, it has far more risk than benefit."

But all the criticism misses a key point. If even the healthier banks are under pressure as a result of the stress tests, those with weaker balance sheets are bound to be hurting. That will, in turn, just speed up the timeframe in which less creditworthy banks make additional capital requests to the government.

When you think about it, that's actually a great thing. The last thing anyone wants right now is to drag out today's kabuki, in which shaky financial institutions can maintain a façade of apparent creditworthiness despite the fact that they'll likely be back, cap in hand, for more bailout money a few months down the road. In the very worst case, stress tests might lead another banks or two to fail. But do we really want those type of institutions making loans in the first place?

Putting banks under lots of pressure now will obviously have certain immediate consequences in terms of lending actvity in general. But at least those that survive the fracas intact will be positioned to take on the economic challenges of the future.