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Why do Banking Regulators bother to Conduct Faux Stress Tests?

By William K. Black
(Cross-posted from Benzinga.com)

One of the many proofs that banking regulators do not believe that financial markets are even remotely efficient is their continued use of faux stress tests to reassure markets. But why do markets need reassurance? If markets do need reassurance that banks can survive stressful conditions, why are they reassured by government-designed stress tests designed to be non-stressful?

Stress tests were first mandated for Fannie and Freddie by statute. Fannie and Freddie’s managers referred to them as “nuclear winter” scenarios – impossibly unlikely and stark disasters. The managers used the ability of Fannie and Freddie to pass the stress tests as proof that the institutions were safe and so well capitalized that they could survive even a lengthy depression. In reality, Fannie and Freddie had exceptionally low capital levels. Fannie and Freddie met their capital requirements under a newly toughened version of the statutory stress test weeks before they collapsed and were revealed to be massively insolvent.

AIG passed its stress test immediately before it failed. The three big Icelandic banks passed their stress tests shortly before they were revealed to be massively insolvent. Lehman passed its stress tests. The stress tests ignored the actual primary causes of losses and failures – extreme losses on fraudulent liar’s loans and CDOs.

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