Distressing Stress Tests

FLORENCE – The stress tests applied to American banks last year are widely credited with restoring financial stability in the United States and removing the fear that major financial institutions might fail. Europeans hope that the recent publication of the results of stress tests that were applied to their own banks will have the same effect. 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.