What exactly is this Bank Stress Testing?

In recent weeks, Federal Regulators have been conducting so-called stress tests at 19 of the US largest financial institutions. The tests were designed to determine just how well or not these most important US banks are able to hold under their current bad loans. These banks are the so called "Too big to fail" banks and as a group, they hold an estimated 2/3 of the assets in the whole US banking system. Among those being tested are JPMorgan Chase, Bank of America, Citigroup, Wells Fargo and Goldman Sachs.

These bank stress tests are important because they could improve public confidence in the financial system. In large part, the economy is hurting because investors lack confidence and the banks themselves are unsure about lending more money even to each other.

One scenario looks at how banks would fare over the next two years based on how the economy was doing in February. The second, more important scenario assumes the economy will sink into a deeper recession than analysts expect. They are also term as baseline and a adverse scenario.

Baseline scenario Economy

a) GDP Shrinks by 2% (adjusted for inflation) in 2009 and grows by 2.1% in 2010.
b) Unemployment -- Averages 8.4% in 2009 and 8.8% in 2010.
c) Home prices -- Drop by 14% in 2009 (from where they ended December 2008) and drop 4% in 2010 (from December 2009).

More adverse scenario Economy

a) GDP Shrinks by 3.3% in 2009 and grows by 0.5% in 2010.
b) Unemployment -- Averages 8.9% in 2009 and 10.3% in 2010.
c) Home prices -- Drop 22% in 2009 (from where they ended December 2008) and drop 7% in 2010 (from December 2009).

Though the result are expected to be announced on the 7th May, Investors are expecting good news and hence reflected the huge surge of equities prices in recent weeks. As these good news are most likely factored into the recent stock prices, we must note that we should take this stress testing with a pinch of salt before we can say the worst are over.

a) The banks might use accounting dodges to keep them away from revealing all the bad loans they have made.

b) The Federal Officials might be too eager to reassure Americans that the worst of the credit crisis is over, and reveal nicer data than they actually looks.