Distressing Stress Tests

But, while the results of the tests may be good for the financial sector, they may be bad for the real economy. The financial crisis is over, but the age of general economic slowdown is only just beginning.

Financial crises have two sorts of effects on the real economy. In the acute stage of the crisis, there is so much nervousness and anxiety that it is almost impossible for anyone to borrow. The inter-bank market dries up, as banks lose trust in one another. Only central banks – typically lenders of last resort – lean against the hurricane-strength winds.

It was the complete collapse of trade credit that sent global commerce into a tailspin for half a year after the failure of Lehman Brothers in September 2008. At moments like these, financial crises look like a heart attack – wreaking immediate and devastating damage to the whole of the economic body.

Indeed, financial stress tests – designed to estimate the likelihood of bank failures in the event of bad economic news – are intended to be the equivalent of cardiac stress tests. And, like most cardiac stress tests, the primary aim is to reassure. We do not want to see another heart attack – or another financial crisis.

The European stress tests, by themselves, were reassuring and produced no surprises. Only one German bank, the notoriously mismanaged Hypo Real Estate, which had already required massive state help, failed. It was also hardly news that the Spanish cajas and Greek banks were in greater difficulties than the rest of the European banking system.

But the stage of post-financial trauma is very different from the heart-attack moment: it is more akin to general heart weakness, in which the activities of the patient are slowed down and reduced.

Historically, the post-crisis consolidation phase has been one in which banks are inclined to be cautious and hesitant. As with heart attacks, the acute stage is usually followed by stabilization, in which banks are recapitalized and the fear of immediate failure wanes.

But that is not necessarily reassuring news for the rest of the economy.

Regulators and governments view the main purpose of financial stress tests as being to persuade some institutions of the urgent need to improve their capital ratios. But major new injections of capital into the banking system are unlikely, owing to lingering fear from the recent financial past.

Instead, the easiest way to improve capital ratios is to cut lending. That was what happened in the major industrial countries in the 1930’s, where an acute crisis in 1931-1933, with some government recapitalization, was followed by a decade of contracting bank lending to private firms.

Where banks did increase their lending, it was the result of political pressure. In many countries, the fall in bank lending was partly offset by an increase in lending to governments, which thought that the banks should recycle society’s savings directly into public-sector spending. Moreover, in many countries, notably in the United Kingdom, banks lent more to homeowners than they did to businesses.

Now, too, as borrowers find credit increasingly difficult to obtain, and as resentment toward banks – and those responsible for regulating them – grows accordingly, we can expect demands for political intervention to alter the distribution of credit.

Fortunately, larger companies are now less dependent on bank credit than they were in the past, thanks to a well-developed market for commercial paper that in effect bypasses traditional bank loans.

But this market is less developed outside the US. Moreover, smaller and mid-sized companies – some of them highly innovative – play a larger role in economic life nowadays but, with no access to the capital markets, remain dependent on banks. It is these companies that will back demands for new guidelines on what banks should do and how they should lend.

The aftermath of the crisis is thus likely to include not only enhanced bank regulation and heavier taxation of many banking activities, but also institutional devices to apply pressure on banks to lend more.

The irony here is that political views of what banking must contribute to the public good are in large part at the origin of the current crisis. The administrations of both Bill Clinton and George W. Bush believed that extending home ownership would generate greater social stability. Legislation from even further back, such as the 1977 Community Reinvestment Act, helped to push banks into providing more financing for housing. Banks responded with ingenious ways of repackaging and selling that debt, but the fundamental problem lay in the channeling of financial flows in an unproductive direction, owing to public pressure.

Judging from past experience, it is likely that the targets of additional lending will be selected according to national political priorities. They will include prestige projects, high-employment companies, and politically well-connected businesses.

None of these favored categories of credit allocation produce the dynamism and innovation that is needed for long-term, self-sustaining growth. Nor, in the end, is politically motivated lending likely to be good for banks.