Today, in money and banking class, we will ask why banks are heavily regulated. This article describes a new approach by regulators to evaluating bank soundness, a stress test
After the financial crisis bank regulators started to use stress tests for banks. A stress test involves checking if the bank would survive an adverse scenario in financial markets. There are many details; the bottom line is that the bank is assessed on the adequacy of its capital and risk management. Banks that come out lacking may be forced to increase their capital by issuing new shares or by merging with another institution; in the worse case scenario their licence may be withdrawn.
What do banks need to do to improve their assessment, and reduce the possibility of failure? Recognize bad loans, write them off and rebuild its capital.
Two points:
- the tests are not perfect: in the past, banks in Portugal and Belgium passed a test and then failed
- the US financial institutions did what they needed to do several years ago. Now the US economy is growing, while Eurozone economies are not.
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