Banks' Stress Test

Date: Friday, September 7, 2007
Author: Arindam Nag, Dow Jones Newswire

Many investors and bankers want the monetary authorities to ease policy to defuse the current credit crisis but it's the banks that need to play their part as well.

They get two chances to do just that this month.

First, about $113 billion of commercial paper comes up for refinancing in September, according to Lehman Brothers.

That's the opportunity for the banks to show they are willing to trade with each other.

Unless they demonstrate that, no amount of liquidity injected by the central banks or reductions in interest rates are going to restore calm on the world's money markets without storing up more trouble with the future.

Secondly, U.S. investment banks are slated to report third-quarter results from next week. They've got to detail exact how they are exposed their credit risk to help investors and central bankers assess where the broader economic dangers lie.

Of course, these two opportunities are linked to each other. The banks' task is to inspire confidence in each other as much as any one else, and it's only then that the central banks will know how much extra work they need to do, say by cutting their base-lending rates, to contain the contagion from the subprime debacle.

Restoring calm to the commercial-paper market - worth $840 billion in Europe alone, says Lehman Bros - remains a daunting challenge.

Buyers of commercial paper need to make a fair-value judgment on the underlying collateral and its liquidity but a large chunk of commercial paper is asset-backed or issued by banks in the form of structured products, explaining why the market has been so close to drying up.

Market participants need maximum transparency about the models the banks have used to price some of these structured securities. That's why the investment banks third-quarter disclosure is so important.

To tempt money managers back to the commercial paper market from the refuge they've sought in cash and T-bills, the banks have to show who holds the economic risk of subprime debt - in other words, which highly leveraged customers the banks are obligated to provide credit.

But that's not all. There's a fundamental weakness to the dynamic stress testing of structured products based on simulations based on past data as well as assumptions such as a 10% stock-market slump or a 1% parallel rise in the yield curve.

The models can't take into account market players' unwillingness to trade.

Things could change over the next few weeks if the banks draw a line in the sand by determining equilibrium prices on structured products.

For that to happen, market players needs to have a fair sense of what the worst case scenario is, which is why Wall Street needs to heed the call by Josef Ackermann, CEO of Deutsche Bank, for investment banks to market their credit exposure to market.

Then the central banks will also know how much they should ease monetary policy - if at all.

(Arindam Nag , a Senior Columnist for Dow Jones Newswires, has covered business and finance for 16 years in Asia, Europe and the United States. He can be reached at +44 207-842-9289 or by e-mail: arindam.nag@dowjones.com)