Is the government’s stress test favouring Wall Street firms over regional banks? That’s what an analysis from the Associated Press indicates.
A Federal Reserve document obtained by the AP shows that the stress tests take a harsher view of loans than of other troubled assets. This would mean that banks holding large loan portfolios would be viewed as being at greater risk than banks holding derivatives and debt securities. Wall Street’s former investment banks and the megabanks—JP Morgan, Citi and Bank of America—have large securities holdings, while regional banks tend to have a relatively larger portfolio of loans.
The AP raises the possibility that the reason the tests are biased in this way isn’t because the whole loan portfolios are actually riskier but because regulators want to make the Wall Street firms and the big banks look healthier. Because these banks are more interconnected to the global financial system, their failure—even if that failure is viewed just in terms of failing a regulatory test—would pose severe systemic risk.
Of course, a real failure would pose even more economic risk. If this allegation is true, it means the government is willing to use the stress test as a cosmetic aid to banks holding toxic assets. This could undermine both the utility of the tests to detect underlying risk and the market’s confidence in the tests to reveal risk.
Under at least one of the scenarios under the stress tests, it is assumed that banks will see “no further losses” on securitized debt. That sounds dangerously optimistic. Losses on the individual loans are assumed to be as high as 20 per cent, which might also be too optimistic but at least isn’t pie-in-the-sky.
For now, no one is commenting about this. Not the banks. Not the regulators. But as this story spreads, government officials will have to address it at some point.
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