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Bank Stress Tests Don’t Matter

Did you hear? Ally Financial failed the Fed’s stress test. [3] Of the 18 banks they tested, 17 passed and Ally Financial failed to maintain a Tier 1 Common ratio above 5% under a “severely adverse” economic scenario. If only these stress tests were performed over five years ago, say before Washington Mutual or IndyMac collapsed, then maybe it might mean something.

Bank stress tests do not matter to me.

When you think about it, bank failures don’t even matter. If the bank gets so stressed that the FDIC has to step in and hold a fire sale, it has no real impact on any of its customers. The FDIC has never lost a penny of insured money and it’s often returned quite a bit of uninsured money after selling off all the assets of the bank. Washington Mutual had $307 billion in assets at the time of failure and IndyMac had $32 billion at the time of failure. Not a single penny of insured funds was lost.

So why bother with stress tests? It’s not a test on the bank itself, it’s a test on the banking system. The idea of “too big to fail” refers not to the actual size of the bank but how intertwined it is with other institutions. Financial institutions hold debt and they also hold insurance on that debt, often issued from other financial institutions. If the insuring institution fails, the insured institution is exposed.

It’s like getting into a car accident and then finding out your car insurance company filed for bankruptcy and won’t be able to pay for any repairs. If you’re at fault, now you can’t pay for the other driver’s repairs. You go bankrupt not because you’re a deadbeat but because your car insurance company failed and the other driver sued you. He has to sue you because he doesn’t have the funds to fix is car and he needs to get to work. As the case goes through the court system, even if to collect from someone with no money, the other guy loses his job because he can’t get there. In real life, we try to avoid living too close to this line but banks don’t. They live this close because they need returns on their money.

That’s why stress tests matter to the system. They don’t matter to you and me. The FDIC matters.

What do you think?

(photo: monsieurpotts [4])