Stress Tests

Lost in the discussion over Treasury Secretary Timothy Geithner’s “stress tests” for banks, which began Wednesday, is this important question: what happens if the government and the independent external auditors reach different conclusions about a bank’s financial condition?

In brief, the stress tests are supposed to determine which banks are viable and which are on their way to the proverbial glue factory. Only the largest banks will be subject to the stress tests. Those that fail the test will be required to raise capital either through private sources or be “allowed” to dip further into the government’s piggy bank. Access to the piggy bank, however, will remain open to all banks. Those who participate will be denied the ability to pay bonuses to their top executives and can only pay at most a penny per share in dividends, while paying the government a nine percent coupon on their preferred shares. These terms aside, it can be extremely difficult, even under normal circumstances, to determine whether a bank is really insolvent or simply facing temporary liquidity difficulties. Will the stress tests give us the right answers?

Geithner has indicated that the Federal Reserve, FDIC, Office of the Comptroller of the Currency, and Office of Thrift Supervision will coordinate on the stress tests to produce an improved assessment of exposures on balance sheets.

In short, Geithner is relying on the same folks who have been responsible for failed regulation over the past several years to conduct the stress tests, basically requesting the supervisors to start doing their jobs. The Fed, for instance, was supposed to be encouraging banks to perform stress testing in their loan portfolios long before now:

An institution’s lending policies should prescribe meaningful stress testing of the prospective borrower’s ability to meet its obligations. Failure to recognize the potential for adverse eventsÑwhether specific to the borrower or its industry (for example, a change in the regulatory climate or the emergence of new competitors) or to the economy as a whole (for example, a recession)Ñcan prove costly to a banking organization.

And the examiners are supposed to be checking the banks. Isn’t one of the reasons that we’re in a banking crisis because of faulty stress testing methodologies and implementation? As the saying goes, garbage in, garbage out.

And isn’t assessing the accuracy of exposures on balance sheets supposed to be the external auditors’ job? Yes. A much better indicator of the financial condition of banks will soon be available in your “must read” 2008 bank annual reports or 10K’s. By law, banks must issue their year-end audited financial statements by March 31, 2009. External auditors have a choice of four opinions they may issue with regards to the accuracy of the financial statements: unqualified, qualified, adverse, or disclaimer. In addition, if auditors have serious doubts about the entity’s ability to operate in the future, an explanatory paragraph known as a “going concern” paragraph explaining why it might not “go on” should be included. Normally, operating as a “going concern” implies that an entity will continue to operate in the near future (generally more than the next year), so long as it generates or obtains enough resources to operate. Including the “going concern” paragraph means the auditors can't give that very basic assurance.

This spring, all eyes should be focusing on whether a particular bank receives a negative “going concern” paragraph or not from the auditors. Whether or not banks have to submit restructuring plans to the government, they must in all circumstances convince their auditors that they will be able to finance their operations over the next 12 months. (Otherwise, the auditors themselves are at risk, not least of being sued by plaintiffs’ lawyers.)

The American Institute of Certified Public Accountants has issued guidance in this area for auditors and recently posted this:

The consideration of an entity’s ability to continue as a going concern is required in every audit performed under generally accepted auditing standards, and is an especially important consideration in the current state of the economy. An entity’s ability to continue as a going concern is affected by many factors related to the current uncertain economyÑthe industry and geographic area in which it operates, the financial health of its customers, suppliers, and financing sources.

As with most things involving accounting, there’s a legitimate element of judgment involved. But with the stress tests, this doesn’t solve the problem.

What will happen if a bank fails a stress test under Geithner’s TARP exam but did not receive a “going concern” clause from the auditor? Who is to blame? Did the auditor hide behind its reluctance to issue a “going concern” paragraph fearing that it might become a self-fulfilling prophecy? Was the auditor not true to his or her ethical and professional code? Should the auditing firm be subject to the same embarrassing treatment that Arthur Andersen endured during the Enron debacle?

Or suppose Treasury’s stress test produces a green light for taxpayer funding but the auditor issues a “going concern” opinion? What happens then? Who should the taxpayer believe? Equally if not more important, who should investors believe – and how will the market react? (Poorly, one assumes.)

It’s actually part of good supervisory practice for external auditors and supervisors to communicate and maintain strong relationships. But given the potential for abuse, however, especially at this critical time, each needs to remain firmly independent for its own tasks.

As they begin their work, all this might make Geithner and his fellow regulators feel a bit . . . stressed.