What do the Stress Tests Reveal About Health of the Industry?

The release of the government's stress testing methodology last week was the latest effort to diagnose U.S. bank industry ailments and set a course for recovery. We will certainly learn more when the actual results are released in May. Meanwhile it is important to understand what these tests can and can't tell us about the health of the industry.Since they were announced, there has been much speculation over whether the testing assumptions are severe enough to accurately assess real-world risks. At least for now, official statements suggest that most of the 19 banks that have been tested are able to withstand a deepened recession. Indeed, according to the government's statement Friday, "most U.S. banking organizations currently have capital levels well in excess of the amounts required to be well capitalized."

This could change, of course, as problems in commercial real estate and credit cards play out over the coming months. Institutions with deep exposure to these products could be in for serious challenges. Similarly, if the recession is much deeper and longer than the tests reflect, then the picture could change significantly.

But while these tests will help identify likely winners and losers in certain scenarios, they are not the final word on the health of the U.S. banking industry. They do indeed provide a "yardstick" for performance under certain stress scenarios. But there are multiple facets of a bank's risk profile that standardized tests cannot fully measure.

For example, some banks, particularly regional players in areas of the country with above average unemployment and foreclosure rates, will struggle far more than average under any nationwide stress scenario. And don't forget that the government is only stress testing bank holding companies with year-end 2008 assets of more than $100 billion. The next 20 largest banks, many of whom are struggling, play an important collective role in the industry -- both as possible failures and acquisition targets as well as important individual roles in select markets.

The banks being tested will find themselves in one of three categories - the strong, the stable and the terminal.

1. Strong. Institutions that are most adequately capitalized will receive the highest marks from the regulators and will be highlighted by the government to reinforce confidence in the system. 2. Stable. Most of the 19 banks fall into this grey area. These banks may need capital depending upon whether or not economic circumstances deteriorate and some may have trouble getting it. 3. Terminal. These banks, while probably few in number, will be unable to raise badly needed capital and will not survive. They will likely end up in FDIC receivership or gobbled up by stronger competitors.

Once the test results are released publicly, the potential for misinterpretation will be high. The results must be delivered carefully to avoid sending the wrong signals to investors and the public at large. For banks, acing the stress test, while certainly a positive sign, doesn't mean they are worry free. Similarly, test results showing banks on the wrong side of the bell curve, while revealing certain weaknesses, will not provide a complete picture of their overall health.

Terry Moore is managing director of Accenture's North America banking industry practice.