Stress tests remain the surest way to restore faith in the world's banks
Doctors make patients jog on a treadmill to see if their hearts can withstand stress. Regulators do the same to banks, minus the treadmill. Financial stress tests run lenders through a simulated workout to separate banks that can stay on their feet in a crash from those that can't.
After a decade of tougher supervision, the stress tests are becoming an easier and more routine affair. Starting with the 2017 exercise, the US exempted most of the 34 banks it tests from the most rigorous part of the exam.
In 2016, European regulators stopped delivering pass/fail grades and turned their test into a biennial event instead of annual. The latest test was criticised for its limited scope - covering just 51 of the region's biggest banks with none in Portugal or Greece - and for using a situation with rising interest rates, rather than the negative rates that are hurting banks now.
The first public stress test, conducted by the US Federal Reserve in 2009, was probably the most effective. In the midst of the worst financial collapse since the Great Depression, the Fed flunked 10 out of 19 banks, identifying a capital shortfall of $75 billion. Europe's turn came in 2010 and 2011, when the sovereign debt crisis piled losses onto lenders that held Greek, Spanish, Italian and Portuguese government bonds.
Two Irish banks passed in 2010 and needed a government bailout later that year. Belgian lender Dexia got a clean bill of health in 2011 and collapsed after a bank run three months later. The European Central Bank, which took over as the supervisor for more than 100 of the largest lenders in the euro area in 2014, made the test tougher, forced the firms to increase provisions for soured loans and required higher capital buffers to cope with them.
When investors suspect that a stress test is too easy, it can create confusion, rattle markets, undermine confidence or even add to worries about which banks might be sick. Regulators fine-tune stress tests to ensure that they are rigorous enough to bolster faith in banks without strangling credit. Banks are opaque companies, and finance is abstract at best, so the worst possible outcome is a test that is neither clear nor credible. Unable to borrow, unable to lend, the banks can become non-functioning zombies.
The tests have given banks and regulators better tools to monitor the relationships that bind together the financial system. That's data they lacked during in 2008, when dozens of banks were failing around the world. Even though the ECB, the Fed and the Bank of England are seen as independent from their governments, political pressure to ease up on supervision and regulation is having an impact. Stress tests are likely to get easier - or at least not get harder - in coming years and become just one of many tools to make sure the crisis isn't repeated.
Sunday Indo Business