Will The Stress Tests' Great Results Endanger Basel III?

By Daniel Indiviglio

On Friday, the world learned that European regulators think that the their biggest banks are mostly just fine. Of the 91 examined, only seven failed the stress tests, all of which have already been nationalized or are relatively insignificant players. Great news, right? If you think the tests are meaningful, then maybe. But could they provide reason for banks to argue more convincingly that global regulators shouldn't raise capital requirements late this year in the Basel III accord?

The purpose of a stress test is to determine, when under extremely difficult market conditions, whether a bank has enough capital to survive. Because the financial intuitions did so well, they could argue that they don't need much additional capital. In fact, John Carney of CNBC believes that the tests are embraced by the market because they provide precisely this certainty:

By declaring that the banks are less risky than bearish investors and pundits believe, they take away at least one very important risk the European banks faced--the risk that regulators would force a plethora of banks to raise capital all at once.

The stress tests are concerned with immediate capital need. But global regulators who negotiate the Basel III accord could also give significant weight to the stress tests. They may believe the tests indicate that banks can withstand another crisis at current capital levels. Of course, the Basel discussions are already underway, and early indications suggest that regulators appear determined to increase capital levels to some extent.

Still, passing the tests will certainly provide banks a strong argument to fight higher capital requirements. And since the new rules haven't been finalized yet, banks are surely continuing to lobby these regulators. The positive stress test results provide the banks a convenient line of reasoning: "But you guys just said we were well capitalized -- why are you making the rules stricter?"

If the stress tests do backfire in this way, it would be unfortunate. One of the few areas of widespread agreement in the financial reform debate is that higher capital requirements for banks would enhance market stability. Should we believe the regulators who say the stress tests were robust or the economists who say more capital will help?

This article available online at:

http://www.theatlantic.com/business/archive/2010/07/will-the-stress-tests-great-results-endanger-basel-iii/60349/