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The Fed Asks, ‘How Bad Is Bad Enough?’

The Federal Reserve is planning to stage the equivalent of a national bank disaster drill, and it is not going to be anything like the cream-puff challenges that some overseas regulators have dreamed up.

The stress test that the Fed ordered last week for the 31 largest U.S. banks includes true worst-case scenarios. Unemployment up to 13 percent, an 8 percent drop in gross domestic product, and a stock market crash of 52 percent from third quarter 2011 to fourth quarter 2012 are the stuff of economists’ nightmares. Very few believe we are soon likely to see any situations this bad, even if European measures to stabilize their credit crisis fail. The Fed itself has said that these possibilities do not represent its own outlook for the economy.

That is what a worst-case scenario is: the chance to imagine just how bad things could get, not just how bad they are likely to get. It is an opportunity to go outside the bounds of the expected and ask “what if?”

The Fed is taking the opposite route of the European banks I wrote about last week. Banco Santander and Banco Bilbao Vizcaya Argentaria announced newly optimistic assumptions about the level of risk attached to their assets in order to bolster their own numbers. The Fed’s tests will force banks to look at themselves without any rose tinting. As Karen Shaw Petrou, managing partner at Federal Financial Analytics, told Bloomberg: “The Fed’s credibility as a tough guy can’t be challenged based on this [test].”

This is as it should be. The crisis of 2008 was largely a crisis of confidence. At the time, no institution knew which other institutions it was safe to do business with, which in turn magnified the uncertainty that was the crisis’ underpinning. The Fed now seeks to provide transparency in advance, in order to slow the spread and soften the impact of any similar panic in the future. The participating banks will also be tested against a European market shock, arguably a more likely scenario than some of the others mentioned.

The Fed’s stress test is the equivalent of boarding up windows in advance of an oncoming hurricane. Even when you can see the storm coming, it’s hard to predict the exact severity. You can hope the storm misses you altogether. If it does hit, you don’t expect to get away entirely unscathed. But some basic precautions can help you to be sure your house will still be standing when the storm is over.

In this case, the Fed has its disaster drill just right.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.

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