Economy: What The Bank Stress Tests Really Mean

The financial world is eagerly awaiting the results of the stress tests for troubled banks. In issuing the reports, the government is walking a tightrope. It doesn't want to paint too dire a picture of the health of America's large banks, which have been hooked up to taxpayer-funded life support for much of the past year. But it also doesn't want to make the banks seem more healthy than they really are. Early results aren't encouraging. Stress-test reports Wednesday morning suggest that that Bank of America will require $34 billion in extra capital to weather potential problems.

But there are good reasons not to put much stock in the stress tests. The notion of the tests is that regulators, economists and executives can project the impact of macroeconomic changes on large, highly leveraged institutions and their debt. But if there is anything we have learned in the past year, it's that the entire financial system, from the Federal Reserve on down to the street-corner economic forecaster, has proved catastrophically unable to make such projections. Given all the complex variables involved, it's extremely difficult to know with certainty how banks will perform in the coming months.

Other, more easily measurable metrics can give us clues about whether the financial system can function without taxpayer life support. The global financial markets provide the results of their own continuous stress test in real time. And while the results are far from satisfying, the data in recent months haven't been uniformly negative. In fact, there are signs that the some components of the system are functioning well without government support.

Take the shortest-term private-sector debt: LIBOR, or the London Interbank Offered Rate, the rate at which banks are willing to lend to one another for a day, or a month or three months. Here's an article on the current state of the LIBOR market, and a long-term chart. The takeaway: since the dislocations of last fall, the rates have fallen back to earth and returned to normal market conditions.

Companies borrow from other companies and investors on a short-term basis through the vital but obscure commercial paper market. In the wake of Lehman's failure, that market seized up, and the Federal Reserve stepped in and agreed to guarantee commercial paper issuance. Six months later, there are signs that the government has been able to remove the life-support tube without killing the patient. On April 29, the Fed was guaranteeing $181 billion of commercial paper, down sharply from $331 billion at the end of 2008. In recent months, then, as this short-term debt expired, companies were either able to refinance without a government guarantee or were deciding not to renew their borrowing at all. That market isn't out of the woods, but the numbers are certainly moving in the right direction, and a significant liability has been removed from the Federal Reserve's balance sheet.

What about longer-term debt? When the credit markets shut down last fall, banks found themselves needing to roll over huge quantities of short-term debt. The Federal Deposit Insurance Corporation started a program to guarantee the issuance of debt with maturities of two or three years by financial institutions. In exchange for paying a fee, the institutions get to borrow at something close to the government rate. Banks have been heavy users of the facility. As of March 31, more than $330 billion had been issued, up from $268 billion in February. But, as Bloomberg reports, there are signs that the healthiest institutions are gingerly stepping out from under the federal umbrella. So far this year, GE Capital, JPMorgan Chase, Goldman Sachs and Northern Trust have successfully issued longer-term bonds without a government guarantee.

In the scheme of things, they are relatively small deals. And Goldman and JPMorgan Chase are still sitting on big chunks of federal bailout money. And while the bailouts and guarantees seem to have stabilized the system at large, many patients are still in critical condition–unable to breathe on their own and susceptible to all sorts of infections. But those deals, combined with those institutions' moves to raise capital (or, in JPMorgan Chase's case, demonstrating that it probably doesn't need to raise capital), provide a road map for a return to health. As the Financial Times reports, the government wants banks to pass to show they can raise capital from the private sector, if needed, and show they can issue debt that isn't guaranteed by the government before they're allowed to pay back their TARP money. In other words, the Feds want banks to prove to the world that the market views them as viable financial institutions that can function with taxpayer-provided crutches. Ultimately, that's a market test, not a government test.