Stress Tests Only Work Through the Promise of Bailouts

One of the key achievements of the Treasury Department since 2009 has been the bank stress tests. Along with the bank bailout, they helped to calm the financial markets. In fact, the stress tests worked so well that Great Britain and now the rest of Europe decided to conduct their own. We should get those results later today. But why have these tests been so successful? It boils down to an assumption that the government will rescue whatever firms pass the tests, if necessary.

Stress tests are not a particularly new innovation. Risk managers have been using them for decades. Indeed, one sub-sector within financial services that has long embraced stress tests is the credit rating industry. The agencies create their ratings by running various imagined loss scenarios. However effectively the company can withstand that stress results in some associated rating.

So the question, then, is why would the market feel better about stress tests when run by the government than by the rating agencies? Usually the market is highly suspicious of the government's financial wisdom. What makes the stress tests different?

One possibility might be that investors have lost faith in the raters, due to their utter failure to properly assess the risks associated with the housing bubble. But the government regulators who perform the stress tests obviously didn't have much clearer crystal balls either. So this rationale doesn't seem particularly plausible.

But there's a key difference between a credit rating agency saying a bank is safe and the government saying so. If the agency is wrong, all it can do is shrug. If the government is wrong, it can apologize for its mistake and make good on its claim with a bail out.

Moreover, there's a strong argument that the government will do exactly that, if it previously indicated that the firm was healthy. It is, after all, the authority. If it's wrong, the market shouldn't have to suffer -- particularly when the government has the ability to bail out investors who trusted the stress tests. If the government intends to hold the rating agencies liable for their mistakes, shouldn't it be on the hook for its own?

As the rating agencies know all too well, stress tests are a very inexact science. They're based on lots of assumptions that allow ample room for error. The problem with crises is that no one can predict how bad things can get, because human psychology takes over as fear and uncertainty grip the markets, pushing logic and sound reasoning aside. No matter how safe a stress test proclaims a firm might be, it could be wrong. But investors love the government's participation because they know its pockets are deep enough to make up for its mistakes.