The results of government stress tests on the 19 largest US banks are due to be announced on Thursday, measuring how viable they are under adverse economic conditions. While all the banks appear to have passed the tests, reports suggest as many as 10 need to raise additional capital.
Given that the economic environment already reflects the tests’ worst-case scenario, and that recent estimates by the International Monetary Fund of financial sector losses have doubled in the past six months, the stress test results will not be credibly interpreted as a sign of bank health. Instead, market participants will conclude that those that require additional capital have, in fact, failed. As a result, these institutions will not be able to raise outside capital and will immediately require government help.
Once again, the question will be how the near-insolvent banks can be kept afloat, to avoid systemic risk. But the question we really should be asking is: Why keep insolvent banks afloat? We believe there is no convincing answer; we should instead find ways to manage the systemic risk of bank failures.
The economist Joseph Schumpeter famously argued that the essence of capitalism was the process of creative destruction by which new economic structures are born from the rubble of older ones. Schumpeter’s biggest fear, however, was that capitalism would collapse from within because society wouldn’t be able to handle the chaos.
Stress Tests and Market Discipline
