The Hindu Business Line : Stress test won’t help US banks

Transmission towers carrying electricity are tested to destruction to see how much load they can take. In the world of medicines, stress test is commonly administered, especially to those suffering from cardiac ailments, once again to determine how far one’s pressure and the resultant stress can go before s/he collapses.

Glucose tolerance test (GTT) also belongs to the same league, to determine whether a person is indeed a diabetic or not. In a way, therefore, stress tests are all about how far an object or person can be stretched before it or s/he collapses.

Worst-case scenario

The Obama administration, grappling with the worst ever economic crisis since the Great Depression of 1930s, has been using stress test, hitherto associated with the world of engineering and medicines, to visualise the worst-case scenario for beleaguered banks and financial institutions.

Several ‘what if’ questions have been asked to find out their putative impact on the bottom line and financials of the harried banks and financial institutions.

For example, what if the real estate prices tumble by a further 20 per cent? What would happen to banks who have lent on the strength of such assets?

At the risk of sounding downright cynical, it must be said that stress test for the beleaguered banks and financial institutions at best would reinforce the gloomy prognoses many a sensible economist has already made. It may not offer anything beyond this because it is clear as daylight that the US financial system finds itself in such a dire straits on account of collective cupidity.

It had stretched out beyond what is permitted in terms of business done in relation to capital as well as a percentage of debt to equity.

To put it more picturesquely, it has been a case of stress brought about by undue stretch. To wit, Lehman Brothers’ debt-equity ratio was an unpardonable 30:1, which would make even a layman wince. He would wince even more on seeing the comparable figures of AIG, reported to be 50:1 before it was bailed out with taxpayers’ money.

Futile exercise

In the event, one cannot help feel that the stress test for banks done in the US is a futile exercise, which can at best confirm one’s deep-seated fears. Fearing contagion effect, already a huge quantum of good money has been thrown after bad. The gloomy prognoses confirmed by stress tests would result in more and more good money going this way.

What perhaps needs to be done is to bring about paradigm changes in the business models of the US banks. Policymakers have all along prescribed cheap money as a panacea for all economic ills. Cheap money resulting in narrower spreads has been goading banks there to indulge in brinkmanship which exotic derivative products are all about.

Borrowers must be made to feel the fear of consequences of default. No-recourse borrowings made by millions of wannabe house owners in fact have turned out to be the villain of the piece. No borrower takes his obligations seriously so long as he is given to understand that he would at the most lose the mortgage property. We in India realise the pain of personal obligation and are, therefore, more circumspect in resorting to borrowings.

The Obama administration should, therefore, get down to brass-tacks and make changes in the ways banks and their borrowers have conducted themselves all these years because this is were the malaise lies.

In Tamil there is a saying, “Kai punnuku edukku kannadi.” Roughly translated, it means why hold a mirror for a boil right on one’s hands. When things are so stark, one should not resort to gimmickry. GTT is required to prescribe appropriate medicines and diet to a diabetic. A treadmill test too enables a cardiologist to plan his medication regime for the patient systematically. A stress test for banks, one is afraid, cannot do any such thing. One should not gear himself to throw more good money after bad, which is what the stress tests of US banks would ultimately result in.

Instead, one should be prepared to initiate roots and branches reforms in the banking sector targeting as much the banks as the borrowers. The Obama administration then should give itself the stress test: What happens if it bites the bullet?

By resorting to the gimmickry such as stress test, it is only postponing the denouement and showing the world that it does not have the stomach to initiate roots and branches reforms in the financial sector. A banker, like an accountant, must be conservative. Time the bankers world over, especially in the US and Europe, were taught this basic lesson. Let us not encourage their foolhardiness by fatalistically saying that banks must be bailed out come what may because of its unique capacity to spread sickness all round.

(The author is a Delhi-based chartered accountant.)

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