Stress Tests: What Was the Point Again?

There was been a lot of drama over the last week, which we have certainly contributed to, about the stress tests. It was all very exciting, finally seeing numbers purporting to show how healthy or unhealthy each bank was. But let’s recall what the point of this whole exercise was.

Depending on your perspective, the goal is either to restore confidence in the health of the financial system, or to ensure the health of the financial system, which are obviously closely related. We care about the health of the financial system because the financial system is critical for the health of the economy as a whole: without banks that are willing to lend money for people to buy houses, cars, and consumer goods, or for businesses to invest in real estate, factories, inventory, software, etc., none of these things will happen. So the ultimate goal is to ensure the availability of credit.

There are ways to measure the availability of credit directly. One of them is the Fed’s quarterly survey on bank lending practices, which was released earlier this week (hat tip Calculated Risk, as usual). For a quick overview, I recommend the charts. The charts show you, for each quarter, the change in supply of or demand for credit in that quarter – in other words, they are you showing you the first derivative.

The quick summary is that lending practices tightened for every category of loans for the seventh straight quarter (in some categories, tightening has been going on even longer). In most categories, the rate of tightening – the difference between the number of banks who say they have tightened credit and the number who have loosened it – is lower than the peak in the October survey. But this just tells us that the second derivative is positive, which was to be expected, since the October peak was the highest ever recorded in every category, when virtually every bank was tightening credit. The first derivative is still negative, which means it is still getting harder to get a loan across all major categories.

Note that the latest survey was taken in April, which is after the banks’ spectacular first quarter results. So despite the major banks’ insistence that they are healthy and they can earn their way out of their troubles – which appears to be the government’s strategy as well – it is still getting harder to get a loan. Now, it may actually be true that the banks can earn their way out, if you look at the second figure, which shows that virtually all banks have been increasing their spreads on commercial and industrial loans every quarter for the past year. As money gets cheaper, competition dies off, and lending standards get tighter, profits go up.

At some point, increasing bank profitability – if it can be sustained – should translate into increased competition, lower spreads, and increased availability of credit. But we are a long way from that point.

The other thing the charts show is that demand for credit has been negative for several quarters in every category, with the exception of prime residential mortgages, which turned positive in the April survey – almost certainly due to refinancing at historically low rates.  So even though we saw increased consumer spending in Q1, it was with lower borrowing. This reflects the expected shift in consumer behavior away from debt and toward saving.

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About James Kwak 133 Articles

James Kwak is a former McKinsey consultant, a co-founder of Guidewire Software, and currently a student at the Yale Law School. He is a co-founder of The Baseline Scenario.

Visit: The Baseline Scenario

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