Enough with bank stress tests

(breakingviews.com) -- US stress tests: The US government slowly seems to be getting the joke of the bank stress tests. On the one hand, regulators want to reassure the market that the country's 19 biggest banks can ride out a recession, with or without more federal help. But until recently, they didn't want to publish the results -- which rather defeats the purpose. Now they're mulling the release of some information. But it would be much better to get it all out in the open.

Just revealing final grades, for example, won't cut it. In fact, it could prompt investors to dump shares in those firms considered least stable and thus spark bank runs that the stress tests are supposedly designed to avoid. That could sap what fragile confidence there is in the financial system and plunge markets back into last autumn's despair.

Instead, regulators should make much more information public. First, they should lay out what happens to each bank's capital under the worst-case scenario, whether they are focusing on tier one or tangible common equity ratios and how low they are comfortable allowing capital to fall.

Second, they should detail what their assumptions are for default and recovery rates on various asset types and whether those assumptions are national, regional or local -- a crucial factor for mortgages, for example.

Of course, unleashing a plethora of data alone also risks bank runs. That's why the government needs a more robust strategy to inject capital into any banks deemed weak by the stress tests. The current plan gives banks six months to raise the necessary money in the private market. But that adds more fuel to the uncertainty. If the Obama administration is unwilling to let any of these 19 banks fail, it should scrap that window in favor of offering to backstop any securities issuance needed to bolster capital.

Combined, these measures should stave off too much panic selling, set clear boundaries and give the private sector enough information to determine whether and how they want to invest in the banking sector. After all, enticing them back in ought to be the ultimate goal of government intervention. But it requires a good dose of openness.