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Michael Brush

Company Focus4/22/2009 12:01 AM ET

Why the bank stress tests are bunk

The Obama team has put banks under the microscope and plans to release the results. If the findings are bad, expect more market turmoil. If they're rosy, who'll believe them?

By Michael Brush
MSN Money

President Barack Obama rode to Washington promising change. But the latest change his team is bringing to banking regulation has many experts on edge.

They fear Obama's strategy to stress-test troubled banks -- and release results, on May 4 -- could turn into a political show or rattle shaky markets. Or both.

Federal regulators routinely test whether banks have enough capital strength to survive extremely difficult economic storms -- a theoretical exercise that's known as a stress test.

But two things are disturbingly different about the tests now being overseen by Obama's embattled Treasury secretary, Tim Geithner:

  • First, politicians are involved, a no-no to banking regulators.

  • Second, after some initial reluctance, the administration will release results. In government, openness is usually a good thing. But it's rare in banking regulation because even speculative results can create turmoil in the market.

To avoid turmoil, the Obama administration may end up whitewashing the results to say the banks are mostly OK. Or it might keep the released results so vague as to be meaningless.

Either of these tactics -- or just the suspicion something squishy had gone on -- would make investors and taxpayers more nervous.

Test of nerves

That's because they know banks still have problems despite the artificially positive earnings numbers released recently by several banks. So we citizens would be left wondering what the government was hiding.

All of this might explain why plans on what to release have changed so often.

"Since these people don't really know what they are doing, they have painted themselves into a corner," says Christopher Whalen, the managing director of Institutional Risk Analytics, which analyzes bank strength and banking-sector trends. "They have publicly committed themselves to some disclosure of stress-test results, and that is unworkable. I don't know how the government is going to get itself out of this trap."

Here's a closer look the dilemma the administration has created, its options and why you should avoid banking stocks despite those first-quarter numbers.

Problem No. 1: Politicians have their hands in the process

Historically, regulators try to stay insulated from politicians. "Only bad things happen when politicians start getting involved with the bank regulatory process," says William Isaac, who led the Federal Deposit Insurance Corp., one of the three main federal bank regulators, from 1978 to 1985.

Sooner or later, politicians try to pressure regulators to go easy on banks run by friends or to put a bank out of business if it competes with one run by their friends.

"I got calls like that when I was chairman of the FDIC," says Isaac, who is now a managing partner at LEGC, a consulting firm that advises banks on regulatory matters. He says he noted those calls in case files, then promptly ignored them. But because he knows that politicians aren't shy about asking for what they want, the overt involvement of politicians in the current tests troubles him.

"Why does the White House even know about the results of the stress tests?" Isaac asks. "In the eight years I ran the FDIC, I never talked to the president about how the FDIC was handling a bank failure. And we handled 3,000 bank failures . . . including many of the largest banks in the country."

Isaac says he did consult with the Treasury about the winding down of Continental Illinois, the biggest bank failure at the time, and one other bank. But in the end it was up to regulators how to proceed.

Isaac left before the savings-and-loan cleanup of the late 1980s and early 1990s, which did involve Congress and the White House.

Regulators routinely look at banks' books to determine whether they have enough capital to back loans and investments, especially when a lot of loans might go bad. When they spot trouble, they work out an agreement to take over a bank and announce it only after it's a fait accompli. The decisions should be based on numbers, without input from politicians.

But with the White House and the Treasury chief now so directly involved in the stress tests, "we are politicizing it in a way that I find terribly discomforting," Isaac says.

Isaac tells me that regulators he talks with are "extremely uncomfortable" and that "most bankers think it is loony."

Continued: Another troubling 'change'

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