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Commentary: Here's a bank stress test that will work
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Forget the negative press about bungled foreclosures, deepening mortgage losses and the veracity of recent profits. U.S. financial institutions are eager to show investors their financial strength.
After a two-year freeze, enough banks have asked for permission to raise their dividend that the Federal Reserve has come up with rules for 19 of the biggest institutions, including Bank of America Corp. (NYSE: BAC - News), Citigroup Inc. (NYSE: C - News) and J.P. Morgan Chase & Co. (NYSE: JPM - News).
In fact, the Fed has just one: that the banks need to pass another stress test.
Cue the eye rolls.
Stress tests, now that we've seen a few here and in Europe, are flimsy propositions. Big U.S. banks underwent the tests in 2009. But they had already been injected with bailout funds. It was like testing a sponge for moisture after adding water. Taxpayer water.
Over in Europe, the stress tests by the Committee of European Banking Supervisors gave all but a handful of small banks on the continent a clean bill of health. And one only need to look to Ireland for evidence the tests may not have been as rigorous as, say, seeing if a banker can tie his or her shoes with Velcro.
That's why the Fed needs to use a test that makes the banks sweat. So without further ado, here are my proposed 10 questions for the banks. Vikram, Jamie — get out your No. 2 pencils.
1. When assessing your balance sheet, which of the following best describes your initial reaction?
a) You're proud of your bank's strong capital position, which has a better-than-required Tier-1 capital ratio, ample reserves and is liquid.
b) You're confident that if the economy booms with an annual GDP increase of 10% to 15%, you can eke by.
c) More holes than an episode of CSI Miami.
d) You feel confident the Fed can handle any potential losses.
2) Should the economy suffer a double dip, what steps would you be willing to take to ensure solvency?
a) Raising interest rates to reward depositors, working with borrowers to keep them current, salary and compensation freezes, stockpiling profits to bolster reserves.
b) Offer free checking for $199 a year. Raise ATM surcharges to $50 and all credit-card rates to 29.99%.
c) Fire my CFO.
d) Tim Geithner is on speed dial.
3) When considering making a loan to a consumer, which of the following is your most important criteria for making a decision?
a) Whether they can pay it back.
b) Whether the government will buy it.
c) My commission.
d) What decision?
4) Which of the following is considered "best practice" for underwriting a mortgage-backed security?
a) Due diligence on the underlying loans and ample disclosure.
b) Making timely payments to Moody's Investors Service and Standard & Poor's.
c) Shovel in, shovel out.
d) Double-checking John Paulson's list against ours.
5) How would you describe your current exposure to other financial institutions via counter-party arrangements, credit-default swaps and other relationships that may pose systemic risk?
a) Minimal exposure, fully hedged and depositors not at risk.
b) Don't ask, don't tell.
c) It's complicated.
d) It doesn't matter because the banks are in great shape.
6) When a borrower calls you because they've lost income and are struggling to make mortgage payments, what's the bank's first step?
a) Work with the borrower to reach a payment level that keeps them in the house.
b) Cancel their credit cards and nuke their credit rating.
c) Surprise.
d) Ask how "party ready" the house is.
7) When subpoenaed by a Congressional committee about your bank's practices, how do you respond?
a) With full cooperation and eagerness to show off the conservative and ethical culture of your bank.
b) Lawyer up!
c) Ask the committee if they want the "on-balance sheet" or "off balance sheet" version.
d) Say "Don't you work for me?"
8) In the event that your bank suffers trading losses that result in the bank reporting a loss for the quarter, what is your response?
a) Apologize, institute risk limits and shrink compensation pools to adjust for investor losses.
b) Stuff happens.
c) Award the trading team a bonus to keep them from fleeing to a hedge fund.
d) Award yourself a bonus.
9) John and Mary are bank tellers. This month John sold $100,000 of investments in the bank-run emerging market funds to customers. Mary sold $100,000 in certificates of deposits. Who has done the better job?
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