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Friday, February 27, 2009

The Unintended Consequences of Bank Stress Tests

CNBC has an interesting story about the unintended consequences of bank stress tests.

The reason: most banks want to avoid taking more government money because of the onerous restrictions the government places on the funds. As a result, they are likely to become even more conservative with their money and pull back on lending—defeating a major goal of the bank bailout in the first place.

"The stress test may well create some unintended consequences, and among those unintended consequences would be the chance that banks would hoard capital leading up to the government examinations," says Greg McBride, senior financial
analyst at

Here is the summary. Banks want to do everything to avoid failing their upcoming "stress tests". If a bank is found to be in stress, that will make it very difficult to get any private funds. As such, banks will hoard any cash because capitalization is key to passing the "stress test". That means that banks will try and lend less because they need to hold onto that money to pass the test. As such, the "stress tests" contribute to the environment of a lack of lending.

The real issue is not the "stress tests" per se. Banks have no money. It's impossible to lend if you have no money. They have no money because they are holding onto billions of mortgage backed securities that lose value each and every minute. That is a problem that is not so easily resolved. It isn't resolved with nationalization, stress tests, or just about any other government intervention. Government intervention only throws good money after bad and creates all sorts of unintended consequences.

Here is the reality. We can't unring the bell. The banks have screwed up and now our banking system is in a state of chaos. There is little if anything that the government can do now. Yet, the government does not have to throw good tax payer money after bad bank money. Stress tests, nationalization and all other government intervention strategies do just that. They don't help. This will be painful. We can all brace ourselves for some pain. On the other hand, we can allow the government to prolong the pain by throwing more money at this problem without being able to resolve the underlying problem. That's what this stress test does. That's what much of the government intervention will do. The law of unintended consequences is here.

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