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Signs That Stress Tests Are Working Well

Against all the odds, it looks like the original plan for government stress tests is actually working out. After causing somewhat of a fracas in the banking sector in April, many firms are reporting that for just now, they will survive the downturn without any further need to raise capital.

The main aim of the stress tests -- which are released Thursday after being delayed -- was to stabilize the banking industry by giving the government an idea of how much money each bank would need to raise in additional capital in a worst-case scenario. The purpose was to avoid a potential repeat of the scene last year, when Lehman Brothers and Bear Stearns went bust as a result of miscalculating their risk profiles, while Morgan Stanley and Goldman Sachs were forced to raise capital in fire-sale deals.
A recent report in the Financial Times claimed that Citigroup and Bank of America are on the hunt for $10 million in fresh funds. Now, Bank of America is denying the accuracy of the report.

"The Financial Times report is completely inaccurate. Bank of America has not been given a final number by the Federal Reserve. The bank is not working on plans to raise $10 billion in common equity," a spokesman for the bank said earlier today.

The comments by Bank of America follow ruminations by banking insiders that the amount of capital that Citigroup would need to raise after U.S. stress test results are finalized is likely to be manageable if the bank needs to boost its equity at all.

And despite a report on Monday which claims that Wells Fargo is one of several banks that regulators will force to hold larger buffers to protect them against possible future losses, investors were bidding shares in the bank up around 10% in morning trading.

By any measure, the initially destabilizing stress tests seem like they are succeeding in returning stability to the financial sector. Part of the reason for that, of course, is that now investors are aware of what will happen given a 22% drop in housing sales and a 10% unemployment rate (which are some of the tests' metrics), they are happy to provide banks with the capital that they need in order to make loans and engage in corporate finance deals again.

One reasonable objection to this show of optimism over the stress tests is, of course, that fiscal policymakers may be testing the wrong variable. Over at blog Naked Capitalism, Yves Smith argues that instead of stress testing the quality of the loans banks make to one another, government officials ought to be analyzing the level of derivatives exposure these firms have on their balance sheets:

As was revealed earlier, the tests are focusing on bank loan exposures. Ahem. The real risk to the system is not in not-too-difficult to value (and sell) loans, but in the complex dreck and derivatives exposures at the big capital markets players, namely Citi and Bank of America. Even if a bank as big as Wells Fargo, a very big bank but in traditional retail and wholesale businesses, were to prove terminally impaired, it might be costly to resolve, but procedurally it would not be pathbreaking.
That's a good argument, and it highlights a fundamental flaw with how financial institutions tend to correct past mistakes: by looking at what went wrong previously, as opposed to what could go wrong tomorrow.

Still, given the lackluster demand for all things derivative-ish today, that's unlikely to be a major cause of concern any time soon. The most important thing is to make sure American financial institutions are capitalized substantially enough so that one failure doesn't lead to a domino-effect of multiple casualties. That's a loan issue, and in that battle, the government appears to be winning.

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