Bank Stress Tests and Your Savings

The financial crisis and health of the banking industry is far from certain, and many are anxiously awaiting results from the government stress tests on major US banks. US regulators conducted a stress test on each of the 19 banks that exceed $100 billion in assets. The purpose of the test, formally known as Supervisory Capital Assessment Program, is to avoid being caught by surprise if one of them is close to failure. The test results will show how much of a safety cushion each bank has to protect against various negative scenarios.

The test used the baseline scenario, which relies on the current consensus estimates, and the adverse scenario, which assumes that the unemployment exceeds 10% and home prices fall an additional 20% by 2011. The results of the test will be made available on May 7, 2009.

The quality and reliability of the tests are questioned by many analysts. The main criticism is that the banks’ own models are used to predict what would happen in each scenario. And those very models caused much of the financial havoc of 2007-2008 in the first place. Furthermore, the scenarios are not particularly scary; in fact, many experts consider the “adverse” scenario the more likely outcome, and nowhere close to the worst case. There is a concern that the stress test will create a false sense of security.

Given all these complex issues, how should a depositor react to the results of the stress test when they are released? The answer is quite simple: ignore them. Every bank is at significant risk, regardless of what stress tests, regulators, or anyone else says right now. The main risk is that, as we saw recently, banks don’t know exactly what obligations they have. Many relationships and contracts are so complicated that no one can tell for sure what will happen.

Luckily, there is a simple solution for a depositor: keep no more than the FDIC coverage limit in each bank. The current limit is $250,000, so if you have $400,000 in your savings account, spread it across two banks. That way, the full amount on deposit is guaranteed by the US Federal government.

Tell us your thoughts.  Do you think that the stress tests will help or provide a false sense of security?