What Is a Stress Test? Why Are They Being Done?

BY busadmin  May 7, 2009 at 10:25 AM EDT

bank squeeze; istockphoto

Question: What are the stress tests? And why are they being done?

Paul Solman: A stress tests is simply an analysis of a bank’s balance sheet. To determine what? Whether the bank is viable as a business. Or likely to go bankrupt instead.

Take the (hypothetical) Public Bank & Savings, aka PBS. Viewers like you pony up the initial capital, for which you get shares in the bank. PBS then sets up shop and starts taking in deposits.

Let’s say it pays 3 percent in interest on them. It then lends the money out at, oh, 6 percent. It uses the difference to run the operation. Any money left over after expenses is profit. (I use these numbers because in the old days – the ’50s and ’60s, for example, banking was called a “3-6-3” business: pay 3 percent, charge 6 percent, and be out on the golf course by 3 in the afternoon.)

Regulation forces the bank to keep something like 8-10 percent of its money set aside as a capital cushion. Initially, it comes from investors, to whose money profits can be added over the years. (The bank shares some of it profits with investors as dividends; the rest the bank retains.) The typical bank also puts aside another 1-2 percent as a “loan loss reserve,” in case loans it makes go bad.

So PBS is covered – up to as much as 12 percent of its total loans: its capital cushion plus loan loss reserve. The actual rules are a lot more complicated, but these are the basics.

Now suppose more than 12 percent of its loans are “toxic” – go bad, I mean to say, as in “We can’t pay you back”?

Well, if the bank were to owe to its depositors more than what it owns – its capital plus the value of its loans – hey folks, that IS the road to bankruptcy. A negative net worth.

So then what’s a “stress test”? An analysis of the bank’s loans to see if so many are potentially toxic that, under certain conditions, the bank’s net worth would be threatened.

Suppose, for example, that the housing market drops by another X percent? Will PBS, with a large portfolio of housing loans, be technically bankrupt, unless it raises more capital to keep a sufficient cushion? Will it, in short, be able to stand the stress? Or will it need to raise more capital by issuing new stock? If it can’t, will the government have to provide money and take stock in return?

That’s what’s at stake. The betting this morning is that the government will determine that the largest 19 banks need, in total, less than $100 billion, though earlier estimates put the figure at between $100 billion-$200 billion in new capital, which the Treasury does not have.

UPDATE: In the above “introduction” to this page, I reassure both readers and myself that a great advantage of this medium is the ability to promptly post and respond to objections, corrections, and refinements. One seems to be necessary with regard to Thursday’s “Stress Test” answer.

Finance professor Zvi Bodie, a frequent contributor to this site, and regular at our new Making $ense economics literacy hub, writes that the following paragraph is in error:
“If the bank were to owe to its depositors more than what it owns – its capital plus the value of its loans – hey folks, that IS the road to bankruptcy. A negative net worth.”

Bodie writes:

Your error is that a bank does not own its capital plus the value of its loans. Its capital is its net worth, although we might also include preferred equity and subordinated debt.

To see this, take a look at the PBS balance sheet:
PBS Bank Balance Sheet
Assets (e.g., $100):
Value of loans + cash and securities + PBS deposits at Fed
Liabilities:
Deposits $88
Capital (Assets – deposits): $12

My response is, well, basically to print Bodie’s correction. I would only add that in a sense the bank DOES “own” its loans. They are the products on which the bank makes money, much like the items on a store’s shelf or the cars in an auto factory, whether they were financed with borrowed or or stockholder money.