First of all, it’s not a stress test, it’s a SCAP …

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The Federal Reserve today released the details of how the stress tests that regulators conducted at the country’s 19 biggest banking companies were put together. The first big revelation: They’re not called stress tests. They’re called the Supervisory Capital Assessment Program, or SCAP.

Regulators were also out and about today telling executives at the 19 bank holding companies (referred to throughout the SCAP paper as BHCs) how they did on the tests, and how much more capital they’ll need to get—from private investors or from government—to be considered safe and sound. But the rest of us probably won’t get the scoop on that until May 4.

The big question all along with SCAP has been: Is it a total joke, or not? If you think the only answer to our banking problems is to mark all bank assets to market and nationalize or shut down those institutions whose assets are worth less than their liabilities, then yeah, it’s a total joke. But banking has never worked that way. The SCAP white paper (SCAPWP) takes a stab at explaining why:

Loans held in portfolio subject to accrual accounting are carried at amortized cost, net of an allowance for loan losses. The use of accrual accounting for these assets is based on BHCs’ intent and ability to hold these loans to maturity, which reflects, in part, a combination of more stable deposit funding and information advantages about the quality of the loans they underwrite. The economic value of loans in the accrual book is reduced through the loan loss reserving process when repayment becomes doubtful, but is not reduced for fluctuations in market prices, which may be driven by market liquidity considerations, if those factors do not affect the ultimate likelihood of repayment.  The adherence of SCAP to current practices is important because the majority of assets at most of the BHCs participating in the SCAP are loans that are booked on an accrual basis.  As a result of the loss recognition framework for assets in the accrual loan book, the results of this exercise are not comparable with those that would evaluate such assets on a mark-to-market basis.

By the way, the acronym for allowance for loan and lease losses is ALLL. The SCAP was an exercise at looking at likely losses in 2009 and 2010 at the 19 BHCs beyond what has already been recognized in ALLL,  estimating pre-provision revenue (PPNR), and seeing if the BHCs have enough capital to absorb the likely losses. Got that? The economic scenarios used in making this judgment were a “baseline scenario” (named in honor of Simon Johnson and James Kwak, I’m sure) in which the economy is expected to shrink 2% this year and grow 2.1% next year and the unemployment rate tops out at 8.8%, and an “adverse scenario” in which the economy shrinks 3.3% this year and grows just 0.5% next year, and unemployment tops out at 10.3%.

Those scenarios aren’t a total joke, although the adverse one has come to look more like a baseline (especially with regard to the unemployment rate) since the parameters were decided in February. I guess we’ll see next week if the actual tests are a joke. But on the whole this does not strike me as a pointless exercise. The idea is to use a reasonably consistent framework to decide which banks are in the worst shape and thus most in need of more government aid and intervention. How that aid and intervention are handled, now that’s another matter entirely.

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