Want to know what a stress test is?
In Europe, the stress test for banks and the likely impact of any results are being keenly watched. But what does a stress test involve? Less than you think.
July 8, 2010 7:05 by Sam Potter
In any business plan, the essential pages are, of course, the financial sheets. Cash flow and profit and loss are basically what any business is about, after all. Amongst the financial sheets of any good business plan will be one called Scenario Planning, or similar. This sheet takes the plan through various hypothetical changes in circumstance, from sales dropping to cost of materials increase. Through it, the business plan displays both the best and worst case scenarios that the business might face, and in effect how bad things would have to get before the company would fail.
It’s business 101, the most basic thinking there is – hope for the best, prepare for the worst. So how can it be that some of the largest, most sophisticated organizations in existence have failed to do something so vital?
The stress-test to which 100 or so European banks are being exposed is all over the news. It is seen by many as a vital indicator of potential future risks, so investors in the markets are waiting with baited breath. Others say it is probably too soft, so not a reflection of a banks actual strength. Either way you look at it, it’s a big deal, and some have called for banks in this region to undergo a similar process.
But here’s the baffling thing: The precise details of the tests are murky, but it hinges around making certain assumptions such as, unemployment will reach 25 percent, and house prices collapse by 20 percent, and so on. Against this back drop, the bank must decide how much it would need to have to survive. If it’s more than it already has, the assumption would be that the taxpayer would have to step in.
In other words, the much heralded “stress test” is nothing more than scenario planning. It’s nothing revolutionary, nothing that will change the industry as we know it or undermine global economies. It is banks, checking if they have enough money to ride out a rough patch. And what’s most disappointing is the fact that this most-basic of actions is obviously coming a few years too late.
This belated application of common sense is infuriating for those of us who are powerlessly caught up in the recession. And you’d be forgiven if you were a little scared to ask, if highly paid and high powered bankers can’t get such basic, important steps right, what hope is there for the recovery?