Should the Bank Stress Tests Be Made Public?

by Sy Harding, StreetSmartReport.com | April 24, 2009

As every business owner who has ever had a business loan knows, lenders have always used ‘stress tests’ to decide whether businesses are likely to survive, should receive the loan they need, or should be forced into bankruptcy. They just didn’t call them stress tests (unless they referred to them that way internally).

Restricting the business owner’s salary and bonuses, and ability to pay dividends, until the loan is paid down to specified levels was also always part of any business loan package.

So what the government, as a lender, is now doing is just normal business practice.

I don’t know what measuring sticks are used as a stress test for banks. But I’ve had a lot of experience with what banks themselves use as tests when they are on the other side, in their role as lenders.

In what seems now like a previous lifetime, I launched several small manufacturing businesses at various times, built them until they were substantial and then sold them. In the process I often used bank loans to get them launched, and subsequent loans to accelerate growth or to buy out competitors.

The stress tests imposed on my businesses by the banks were very similar to the tests the government has been applying to the auto-makers, and is now using regarding the banks.

Basically, again as any small business owner knows, it began with providing a written business plan that made sense, that showed how the loan would be used to achieve the stated goal, of either launching a successful new business, or producing further growth once the business was successfully operating. That’s a test the automakers apparently failed right out of the gate, unable to come with a believable written plan of how they would use government bailout loans to turn their failing businesses around.

A business plan also includes pro-forma financial statements, projections of what the business’s financial condition will be after the loan, and well into the future. Considerations include whether the ‘current ratio’, a method of measuring a company’s financial liquidity, will remain within acceptable limits so the company will be able to readily meet all its goals and still be able to make the loan payments.

Those measurements of financial health become part of the ongoing ‘stress tests’ as each quarterly financial report is sent to the bank. Let the current ratio for example, fall under acceptable limits and you’re going to have some explaining to do.

To make sure the borrower uses the loan for the stated business purposes and does not siphon off part of it for personal use through pay raises and bonuses (as many banks seemed to do with Treasury Secretary Paulson’s first installment of ‘unrestricted’ TARP loans last year), business loan agreements typically restrict the business owner’s salary, bonuses and dividends until such time as the business can clearly afford them without jeopardizing the loans.

Are there ways of circumventing some of the restrictions? As any small business owner also knows, the answer is yes. Banks are dealing with all kinds of businesses and cannot know the inner workings of each type of business in detail. So there is no way they can cover all possibilities. There are always ways for an owner to quietly increase his or her compensation as the business succeeds without waiting for the bank to remove its restrictions.

Are there pressures to pay the loan off early to get out from under the restrictions, even if paying it off early is not the best use of the earnings for the business? Absolutely.

So what is going on now seems fairly normal. Except that it’s on a much grander scale of course, and is under the probing, but not always comprehending, eyes of the public and the media.

The government, in its role as a lender, is finally beginning to follow good business and lender practice in requiring written business plans, applying stress tests on the borrowers, and restricting salaries and bonuses.

But the government has the same problems banks have when they make loans to businesses. It can’t possibly know (or quickly learn) as much about the details of how these complicated banks operate as the insiders know. So the controls will not be perfect.

That’s the way it goes in business. There’s not much that can done to make plans perfect without over-fussing and bringing progress to a halt.

However, while I like what the government is doing now, I question whether it will turn out to be right in making the results of the stress tests public.

Let’s put it in the perspective of local businesses near you which have loans with local banks. Neither the public nor investors in those banks are told which local businesses may be close to financial trouble. All the investors can know is the level of the bank’s overall loan losses and loss reserves, not the names of individual businesses in potential trouble. And for good reason. That knowledge would guarantee some of those businesses would fail (and not repay their loans), because customers would go away, and other businesses would stop doing business with them except for cash.

But tax-payers, now stock-holders in the financial system, insist they be told which individual banks are not doing well in the stress tests, and the information will be released May 4.

Unintended consequences may be a roiling of the financial sector that the government’s efforts are aimed at stabilizing, in the same way that a list of financially troubled individuals or businesses in your home town could roil confidence and conditions there for awhile.

For instance, will depositors create runs on their banks if they are named as not doing well in the stress tests? Will investors bail out of their stocks in panic and send the financial sector reeling again?

Sy Harding publishes the financial website www.StreetSmartReport.com and a free daily Internet blog at www.SyHardingblog.com. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!

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