Were the bank stress tests stressful enough?

Last week, federal regulators released the long awaited results of the stress tests of the 19 largest US banks. After months of testing, it was determined that 10 of the 19 banks need to raise an additional $75 billion in total capital to withstand future losses should the recession deepen. Two scenarios were run based upon rising unemployment and falling housing prices. Under the more adverse of the two scenarios, regulators estimated losses at each bank resulting from a scenario in which unemployment hits 10.3% and housing prices fall 22%. Many argue that this scenario is not severe enough as unemployment is expected to hit 10% by year-end, just shy of the most severe stress test. The good news is that the banks are working to raise the capital through stock offerings and asset sales such that very little new taxpayer bailout money is expected to be needed.

I decided to see how the government’s stress test results of the banks’ capital structures matched up against a stress test of stock performance using the same stress factors and stress amounts, but in a multi-factor risk model framework. I created a portfolio of the 19 stocks and applied the worst case government scenario to evaluate the potential impact on the stock returns of these 19 banks. I ran the stress test as of February to be comparable to the published stress tests. I used the R-Squared Global Equity Risk model in the analysis.

The report lists the capital needs, market capitalization, and capital needs as a percent of market cap for the 19 banks. The last three columns show the predicted impact on stock performance given a scenario of unemployment rising to 10.3%, housing prices dropping 22% as measured by the S&P/Case Shiller Housing Index, and a third scenario which combines the first two. This third scenario is comparable to the stress tests performed by regulators. Of the nine banks the Fed determined not to be in need of additional capital, seven are at the top of the performance list based upon this stress test. The bottom six performers under my stress test are the banks most in need of capital as measured by percent of market cap. Note that the stock performance of GMAC is hard to account for since it is a unit of GM.



So the government’s stress test of capital needs and this stress test of stock performance are actually very much in line. Whether the unemployment and housing price scenarios used in the stress tests were severe enough is another question.