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Will the Stress Test Restore Confidence?

Although the government has previously said that distressed banks need to raise additional capital to meet the strict standards of the “stress tests”, the Obama administration also revealed that it is ready to provide help if the banks needed it. Performed on 19 financial firms, the stress test is intended to boost consumer confidence. It is important to take note that the 19 major firms account for half the loans in the United States banking system and it has become a big part in the government’s rescue plan.

Restoring Consumer Confidence

With today’s economic crisis, you, your friends, and your loved ones might be cutting back to save up for any unforeseen circumstance. This causes great damage to the economy if majority of Americans are doing the same thing. The government wants to stop this trend by assuring the public about the relative strength of the financial sector. Once investors and the public are assured that the country’s biggest financial firms are stable, recovery can begin at a faster pace.

The Federal Reserve has already held top-level meetings with bank executives to give them the lowdown about what the status of certain banks will be if the recession got any worse. Senior Fed officials assured the public that they will keep a close eye on banking institutions to ensure that they have sufficient capital to withstand major economic shocks. The results of the stress test will be announced on May 4. Already, its effects are being felt in a positive way. Wall Street is brimming with anticipation and the Dow Jones Industrial rose by 119 points to close at 8,076.

Criticism of the Stress Test

The concept of the stress test has garnered both praise and criticisms from economic experts. Some critics maintained that the stress test may achieve the opposite effect of what the government wanted. The uncertainty that it creates feels on market volatility. In addition, the market may not accept the hypothetical testing as a realistic one.

How the Government Will Help

The philosophy that major financial firms are “too big to fail” seems to be a fundamental one. The Fed can use several tools to improve a bank’s balance sheet including converting Treasury loans into the bank’s common shares of stocks. Another method would be to compel financial institutions to raise more capital from private market to get more money from the bailout fund. If worse comes to worse, the rescue plan may involve a government-backed merger.

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