THE STRESS TEST CONUNDRUM

I am perplexed by a number of issues with the so-called stress tests being carried out at our nation’s largest banks by assets, those with over $100 billion in assets. Regulators have been on airwaves this week claiming that given current market conditions, these banks are healthy—namely they are sufficiently capitalized now. We are told, the stress tests are only to determine whether they will need additional capital if and only if macroeconomic conditions deteriorate further from where we are today— unemployment climbs to above 10% and housing prices decline by another 25%. Furthermore, we are told that the stress tests will be uniform for all the banks; namely regulators will be making their determinations with the same metrics across all the 19 financial institutions undergoing these tests.

Many unanswered questions remain. First, how are regulators marking the banks’ portfolios? Are they using mark-to-market or mark-to-model? Given the parameters for the stress tests that have been revealed to us this week, it is clear that regulators are using mark-to-model. Why is it clear? Because the parameters regulators have told us they will use are assumptions that are inputs into models not markets. Markets do not need inputs—they just need a bid and an ask. The bid and ask may be very wide. The bid/offer spread is a function of liquidity—the wider the spread, the more illiquid is that market. But the bid/offer spread determines where the market is, however illiquid.

Second, given that regulators are using mark-to-model, then what are the models? Are they models developed by regulators that will be applied uniformly across all the banks being stress-tested? Or, are regulators using the internal models of each bank? If the internal models of each bank are being used, then there is clearly no uniform model being applied across all banks. Besides the need for uniformity in modeling techniques across all banks for the stress tests, the data inputs into the models need to also be uniform across all banks. Where is the data for the models coming from? Is the data coming from the banks or from the regulators?

Third, why are regulators using mark-to-model? Why not mark-to-market? Mark-to-model has led to considerable ambiguity among the investor community as to the actual valuation of the banks’ portfolios for all the reasons elucidated above—this incertainty has fed speculators shorting financial stocks. We risk further ambiguity and further speculation in financial stocks (with all-too-real risks of contagion to the broader market as witnessed in the past six months) with regulators continuing the current practice of banks of using mark-to-model to value their portfolios.

The only transparent and uniform valuation mechanism is the market—even one with wide bid/offer spreads. Regulators could begin, as a point of departure, by applying a real stress scenario for market conditions today. Namely, they could start by marking bank assets at today’s bid prices not the ask prices— a practice, as we know, shunned by banks in the current crisis. Then regulators could apply stress scenarios that could transpire in the future if the economy deteriorates. These stress scenarios would be one where bid prices for assets decline further from current levels by say 10%, 25% and 50%. Then regulators can meaningfully measure the impact on banks’ capital under these stress scenarios.

Mark-to-market gives a level of transparency and uniformity not conferred by mark-to-model. One would imagine that, given the havoc caused by the financial sector, our regulators would want to employ the most transparent valuation mechanism and the most “real” stress scenarios to get a handle on the actual capital health of our nation’s largest banks. We can no longer afford to dance around the important issue of adequate bank capitalizations now and under worsening market conditions. The metrics, however, need to be transparent and uniform. And yet they are not. Our regulators are still dancing around these important issues, thereby sowing the seeds for further uncertainties and speculative runs on our financial institutions and the wider markets.