Memo to the President: Replace stress tests with viability plans

19 financial institutions (FIs) are undergoing so-called "stress tests" to determine whether they need to raise more capital. As I posted, these 19 institutions hold $608 billion in toxic waste, formally known as Level 3 assets. Now there is major drama in Washington about whether to release the stress test results on May 4th. Let me settle this one for you -- cancel the stress tests now and require TARP recipients to produce viability plans.

There are two reasons to cancel the stress tests:

  • Stress tests are flawed. How so? First, the scenarios are overly optimistic. For example, under the tests' "more adverse" scenario, the unemployment rate is seen rising to 10.3% in 2010. When Treasury picked that number the actual unemployment rate was 7.6% -- it's since risen to 8.5%. More importantly, the basic idea of the Treasury forecasting the capital needs of these 19 FIs is deeply flawed -- that's because there is no way that the Treasury can know enough about each of them to use a few economic statistics to predict how much capital they'll each need.
  • Releasing the results will confuse the public and panic investors. Needless to say, it will be impossible to explain these flawed spreadsheets to the public. Consumers will panic and take their deposits out of the FIs that fail the stress tests and put them in ones that pass. And investors will be placing bets on which FIs are going to fail thereby accelerating the rapid decline of any bank that can't cut it.

I realize it's not helpful to present a problem with no alternative solution. So here's mine: I would suggest that you require TARP recipients to produce their own plans for viability -- like the ones that were required for the auto companies. Such a viability plan would be management's forecast of the FI's future cash flows -- with the idea of demonstrating how the TARP recipient would repay -- with a profit for taxpayers -- the money it's gotten and/or needs to get.

Why is this a better approach? Here are three reasons:

  • The viability plan will be based on more in-depth knowledge of each FI. Since each FI will prepare its own viability plan, it will know much more than Treasury about its future cash flows and how economic adversity might affect them. Given this additional insight, the numbers have a chance of being more credible.
  • The FI will feel greater ownership of the results. Since the survival of each FI will depend on the plans, the FI's management team is likely to have an incentive to make the plans as realistic as possible. But there will be a natural inclination to be optimistic which is why the viability plan should include different scenarios which Treasury could supply. And Treasury should also require each FI to make its assumptions explicit.
  • Treasury is in a better position to review and question the results than to create them. Treasury, or perhaps an FI viability task force, should review the plans and get each FI to respond to questions that will inevitably arise about the plans' realism. It is a far better dynamic for the government to be questioning the viability plan than to be defending a poorly constructed stress test.

If your goal is to strengthen the global financial system, then you want to encourage consumer confidence and minimize the cost of fixing big problem banks. Releasing stress test results will make these goals harder to achieve. Demanding viability plans will put the system on a sounder footing.

Peter Cohan is president ofPeter S. Cohan & Associates. He also teaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.

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