In order to gauge the strength of the U.S. banking system, the Federal Reserve (Fed) required banks to complete their third stress test since 2009. Developed after the financial crisis as a spindly string attached to the Big Bank bailouts, stress tests are now an annual exercise for the nation’s biggest lenders.

Taking preventative action, stress tests aim to locate banking institutions’ weak areas at an early stage. As part of the stress test, banks are subjected to unfavorable hypothetical economic scenarios and must manipulate their capital ratio to maintain liquidity and meet specific reserve requirements above regulatory minimums. Stress tests focus on fundamental financial perils, such as credit, market and liquidity risks, to assess banks’ financial health and determine whether they have enough capital to endure the impact of an economic crisis.

Notably, stress tests do not review the status of assets to deposits test.

Of the 19 largest U.S. banks tested, 15 were able to manipulate their capital ratios, which compare high-quality capital to risk-weighted assets, above four separate regulatory minimum levels. Still, the Fed criticized how some of these banks calculated potential losses and dividend payments.

Evaluations from the Fed are in the process of being sent out to lenders addressing a bank’s management of their capital to limit the risk of future taxpayer bailouts.

Four major lenders, Citigroup Inc., Ally Financial, SunTrust and MetLife, did not pass the stress test, and have requested greater transparency from the Fed in terms of what is expected from banks during testing. Any companies that did not pass the stress test must submit their revised plans by mid-June of 2012.

Overall, lenders are resisting the Fed’s efforts to implement strict regulations on too-big-to-fail banks, and have protested that stress tests stifle lending and destabilize the market. Lenders, unsurprisingly, have complained that stress tests underestimate the lenders’ underwriting abilities, resulting in higher losses than projected.

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With the financial system’s current state, it is uncanny that the Fed is choosing to spend time toying with imaginary scenarios. The existing financial crisis facing the U.S. economy is not simply a matter of dealing with hypothetical economic situations and controlled financial factors.

In this calamitous disintegration of the nation’s financial structures, economic downturn has been brought about not by stress, but by the failure of government’s regulatory entities to regulate and adjust regulations and audits to changing market conditions so conduct going forward will not place us in the same situation when the economy recovers.

By keeping the now-insolvent too-big-to-fail banks afloat, government entities have created the artificial appearance of their solvency. Similar to the way the U.S. bolstered large failing banks, other countries in recent financial crises allowed insolvent banks to remain in business by offering them favorable interest rates — like zero interest on all the funds needed to cover all the non-performing mortgage amounts.

Responding to Mexico’s economic crisis in the 1980s, the Mexican government sustained banking activity through socialization, but an unequal application of policy resulted in great economic disparity between taking over the larger banks with assistance and smaller ignored banks. Similarly, Japan’s government supported the management of large failing banks during the Japanese financial crisis in the 1990s.

Both countries also implemented large scale financial stimulus programs to artificially support employment and investment values. After their financial crises, both Mexico and Japan experienced decades of slow growth and economic stagnation.  Mexico, 20 years on, is now finally showing economic growth, while Japan still has depressed real estate prices at half its prices 20 years ago.

By contrast, in response to Chile’s 1980 financial crisis, the Chilean government seized the insolvent banks and established tighter banking regulations. Within three years, the banks were privatized and interest rates and loan amounts were again determined by the market. In the 1990s, the Finnish government responded to their country’s financial crisis by allowing the market to determine how loans were granted. Both countries experienced immediate sharp drops in short-term GDP, but have since grown at extraordinary rates.

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By imposing stress tests on banks as market regulation, the U.S. government is ignoring reality through allowing insolvent banks to continue operating. Banks still servicing bad loans on non-performing assets are distracted, with no time to focus on generating new loans. Unlike Chile’s and Finland’s decision to mark-to-market, or match home mortgages amounts to home market prices, the U.S. is following in the footsteps of Japan and Mexico by choosing to mark-to-management (whatever number makes them solvent on paper), ignoring market values and inadequately nursing the economy along.

As the Fed spends time fiddling (anyone with a violin to hand them) with hypothetical situations that mean nothing to the real economy, the financial system remains in disrepair. With no discussion of solvency, the Fed is allowing banks to prolong any national economic recovery. Unless home mortgages are marked-to-market to fix the economy now with a reality check, any partial fixes will further stagnation within the California housing market for years to come.

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