Bank Stress Tests: Self-Fulfilling Prophecy?

The US regulators have just released the results for the “stress test” of the largest US banks. As predicted based on early rumors, 10 banks out of the 19 tested need to raise additional capital, with Bank of America (BofA) leading the list at $34 billion.

Banks That Need to Raise Additional Capital:

• Bank of America (BAC) – $34 Billion
• Wells Fargo & Co. (WFC) – $13 – $15 Billion
• GMAC LLC – $11.5 Billion
• Citigroup Inc. (C) – $5 Billion
• Morgan Stanley (MS) – 1.5 Billion
• Regions Financial Corp. (RF) – Amount unknown
• Fifth Third Bancorp – (FITB) – Amount unknown
• KeyCorp (KEY) – Amount unknown
• PNC Financial Services (PNC) – Amount unknown
• SunTrust Banks Inc. (STI) – Amount unknown

Banks That Are Not Required To Raise New Capital:

• JPMorgan Chase & Co. (JPM)
• American Express Co. (AXP)
• Goldman Sachs Group Inc. (GS)
• Bank of New York Mellon Corp. (BK)
• MetLife Inc. (MET)
• Capital One Financial Corp. (COF)
• State Street Corp. (STT)

The first thing to note is that, according to the test, none of the banks are in danger of bankruptcy any time soon. The new capital that Bank of America is told to raise is only required to make it more stable; the bank is perfectly solvent as it is.

This actually pushed the share price of BofA stock up 17% the day the news was leaked (yesterday), and another 6% the day of the official release (today, May 7, 2009). This shows that investors pay a lot of attention to the stress test, and were relieved to learn that with “just” $34 billion in new funding Bank of America will be fine. Of course, all the other banks are even better off, as their capital needs range from zero to $15 billion. And with the government obviously judging all of these institutions “too big to fail,” there is little doubt that the fundraising will be a relatively easy matter.

Unfortunately, as we discussed in an earlier article about “Bank Stress Tests and Your Savings,” these stress tests are not very tough at all. In other words, even if a bank passes the test with flying colors, it is far from certain that it can weather a real economic crisis. After all, the worst case considered in the stress tests was that by 2010 the unemployment rises to 10.3%, house prices fall by 29%, and real GDP falls 2.8%. Some economists, such as Professor Nouriel Roubini of New York University, predict house prices decline by 44% and a much deeper recession, with GDP down 5% by 2010.

The good news is that the general public feels comfortable that the situation is under control and the worst is already over. Such positive sentiment is actually very beneficial to the economy, as it means increased consumer spending. In other words, the stress tests may become a rare example of a helpful self-fulfilling prophecy: if most people believe in it, the economy is indeed likely to perform better.

What do you think? Does the government have everything under control and the worst already over?