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Do Bank Stress Tests Mean Anything at All?

One week ago the nation's largest bank holding companies all managed to get a passing grade on the first round of a two part stress test conducted by the Federal Reserve. The tests were designed to assess "their ability to withstand an extremely adverse hypothetical economic scenario." Later today the Fed will pass judgement on each bank's capital distribution plans, including buybacks and dividends; a decision which will be much more meaningful to banks like Citigroup (C) presumably champing at the bit to increase its dividend yield above 0.1%.

Dan Alpert the founder and managing partner of Westwood Capital suggests the tests are as much about perception as financial reality. "The stress tests overall is really an example of the Fed, particularly Dan Tarullo, keeping his feet on the neck of the banking institution." Suffice it to say the banks themselves object to both the testing and the notion of having Mr. Tarullo's foot on their collective necks.

That antipathy and the limitations of the testing process were on full display last year when banking representatives led by JP Morgan's (JPM) Jamie Dimon met with Tarullo in a closed door session. According to reports at the time, the meetings were centered around the banking execs' frustrations with examinations as well a preemptive strike against still pending rule limitations regarding banking activities. Less than a week later Dimon and JP Morgan announced a surprise trading loss on massive bets placed by a division ostensibly charged with minimizing risk in the banks holdings.

Alpert says the stress tests still mean very little as a practical matter. The exam assumes conditions including a 50% drop in equities, a rise in unemployment to 12.1%, and a 20% decline in housing prices lasting for 2 years. "The conditions and assumptions that are in the test are horrible," he says in the attached clip. "If you had that kind of nuclear melt down what you'd have after 24 months would be carcasses of banks."

The tests are better than no regulation at all. The Fed is operating within its limitations while still sending a strong message to the banks that they are being watched. Hypothetical financial models with specific assumptions such as those in the stress tests are mathematical monuments to man's stupidity. Black box modelling has never worked and never will. But watching the banks more closely than the laissez faire approach of the a decade ago is worth some sort of effort, futile though the desired result may be.

Expect most if not all of the banks to pass this round. Capital distribution plans will most likely be approved but only with some specific, if symbolic restrictions, just so the Fed establishes who's boss. Should you sleep better at night knowing our banks are safe from an unforeseen catastrophe? Obviously not, but in a market where junk debt is yielding a mere 5.6%, investors would certainly welcome dividend increases from relatively stable financial institutions.