The Federal Reserve on Tuesday released the results of another round of stress tests on big U.S. banks, telling investors what would happen to these companies if the economy suddenly and unexpectedly tanked.
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Three years after Tim Geithner and other U.S. regulators forced big banks to undergo stress tests, these once little-known tools have become a fixture in the post-crisis risk management of financial-services companies.
Some believe they should now be applied by non-financial companies, as well, to prepare them for potential storms on the horizon.
“Geithner’s stress tests concept should be embraced and adopted by corporate America,” Bill Bartmann, CEO of Bartmann Enterprises, said in an email. “Most businesses ‘hope for best case’ and stick their head in the sand when it comes to analyzing risk in an ever-changing business environment.”
What Are Stress Tests?
Stress tests are forward-looking tools that are used to predict what would happen to companies’ portfolios and balance sheets if certain economic gauges deteriorated to given levels.
For example, the Federal Reserve’s stress tests, which were conducted on systemically-significant banks, calculated how banks would be hurt if the stock market plummeted 50%, home prices plunged another 21% or the unemployment rate spiked to 13%.
Often, stress tests take into account previous historical scenarios such as the Asian currency crisis or the bursting of the dotcom bubble. Other times they can plug in situations that haven’t happened but may eventually, such as the exit of Greece from the eurozone.
Led by Geithner, the U.S. government forced big banks like Bank of America (NYSE:BAC) and Citigroup (NYSE:C) to submit to stress tests during the darkest days of the financial crisis in early 2009.
Stress Tests Restored Confidence
While many were skeptical of their merits, the results of the tests eased the crisis of confidence and helped stabilize the system. Even though some big banks failed, investors were no longer as fearful of the unknown.
“A recession is just as interesting to a consumer-products company as it is to a financial-services company."
“That was a major turning point in our psyche,” said Ernie Patrikis, former general counsel of the New York Federal Reserve and now a banking partner at White & Case. The tests helped “turn around our confidence in the banking system,” he said.
Prior to the crisis, banks relied heavily on a measure called VAR, or value-at-risk. During good times, this backward-looking risk management tool worked well to measure the potential loss on a given portfolio at a given time.
However, in many cases VAR failed to hold up in 2008, which represented the worst financial crisis since the Great Depression.
“People felt [VAR] let them down and hadn’t warned them about the types of risks they were exposed to,” said Mat Newman, vice president of product management at SunGard Adaptiv and a risk management veteran. “You don’t know when things are going to get bad. It kind of sneaks up on you.”
Today, stress tests have become an inherent facet of banks’ risk-management structures. As part of the Dodd-Frank financial overhaul and Basel III, global banks deemed to be systemically-important must undergo supervised stress tests.
"If you're a director of a major financial organization in the United States and you are not actively overseeing your organization's stress testing, there is something wrong with your organization," Patrikis said.
To be sure, stress tests are far from perfect. In fact, the tests are only as strong as they are stringent. Many investors were critical of an early round of stress testing in Europe because their “worst-case” scenarios were deemed to be far too rosy.
“If it’s not tough enough, it’s not only worthless, it’s perhaps less than worthless,” said Patrikis, who said scenarios thought to be too bullish will make people think, “They made the test too easy because they know they can’t pass it.”
What About Non-Banks?
While stress tests have principally been used by the financial-services industry, there may be a role for them in other parts of the business world.
After all, banks weren’t alone in being unprepared for the severity of the ’08 downturn, which slammed every sector of the business spectrum from automakers to PC makers.
“A recession is just as interesting to a consumer-products company as it is to a financial-services company,” said Newman, who cautioned that predicting consumer spending tends to be “more of an art than a science.”
Still, perhaps if General Motors (NYSE:GM) and Chrysler had been better prepared for double-digit unemployment and the freezing of the credit markets they wouldn’t have needed to file for government-assisted bankruptcy protection.
“It is exceedingly rare to find a business that has actually asked itself the questions that are inherent in a stress test, ‘what would we do if the worst case occurred?’ If every business had to ask and answer this simple question honestly (and privately), the enterprise would be better equipped when challenges arose,” said Bartmann.
Non-bank stress tests can also try to prepare companies for events such as the surprise death of a CEO, a supply-chain incident like the Japanese earthquake of year ago or a debilitating legal challenge.
Ultimately, it seems that shareholders would benefit from a company that uses stress tests to brace for that what-if situation like 2008.
“Stress testing makes sense,” said Rich Horwath, CEO of the Strategic Thinking Institute. “Great corporate strategy involves risks. Any time a company can become more competent at risk management they’re going to become more effective at generating a strategy that enhances shareholder value.”