Over the past one week there has been a lot of hype over the Stress Test results for US Banks. The results were declared on 7th May and created an immediate uproar in the markets. The results were quite reassuring with US Banks requiring $75 billion in additional capital.

Let us first try to understand what stress test means really? Its real name isn’t stress test, the real name is actually Supervisory Capital Assessment Program. It is probably a bunch of excel simulations assuming various cases for the economy to reveal which banks have sufficient capital to withstand this horrible recession and which don’t. Actually according to wikipedia two scenarios were considered – Baseline and Adverse.

Although the results came out to pretty fine for almost all the banks (or atleast the media is projecting it this way). But lets try to imagine that if a real stress was conducted and some banks came really short then what would happen!

Government: Bank A is short of a lot of capital and Bank B is fine (in another words Bank A might not survive and Bank B should)

Customers think “Damn it! If Bank A can fail then why do have an account in it? Why do I have deposits with it or anything? Lets take them all out and move to Bank B”

Customers: Bank A please give me back all my deposits, my securities, and close my account with you.

Bank A: But I don’t have all that money with me! I can ask companies to whom I have given this money but they won’t be able to return this money right now as well!

Customers: Tough luck dude! I want the money now!

Bank A files for Chapter 11 Bankrupcy.

But ofcourse luckily for us this did not happen. All the banks were almost within limits or will issue more equity to raise capital. This actually creates a different situation where people have started having faith in the financial system again (which is great!). Stock markets have jumped and we may just move out of the recession! Great move by the Fed. Lets hope this strategy works.

Update: An article was published in the Wall Street Journal claiming that Banks actually got concessions while stress testing them and the actual need was more than shown in the results. Thus probably the whole point of the stress test was to show banks are strong!

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