Everyone is talking about Fed’s stress test on banks. Fed is planning to release basic details of stress test tomorrow. What is this stress test? What is being tested?

The stress tests rely on a series of computer-generated “what-if” projections in the event the economy deteriorates further. Those include unemployment rising to 10.3 percent by next year, home prices falling an additional 22 percent this year, and the economy contracting by 3.3 percent this year and staying flat in 2010. Federal Reserve tests the large U.S. banks’ performance under two conditions: baseline scenario and more adverse scenario. The tests are conducted to find out whether large U.S. banks have sufficient capital buffers to withstand the impact if the economy worsens.

In other words, Federal Reserve is trying to find out who will be the next Lehman Brothers. Even if there is one more Lehman out there, Federal Reserve will not let that bank fail. FDIC published detailed FAQ on stress test; it’s useful to understand what is happening.

According to New York Times, the banks were asked to project their earnings over the next two years to give the regulators a better sense of how much capital they would have to absorb the coming losses.

Tomorrow, Federal Reserve and other banking regulators are expected to release a “white paper” that outlines how regulators went about conducting stress tests. It will include assumptions about the losses firms could face for loans and securities under different economic scenarios. Fed plans to release the results of stress tests on May 4th.

Nouriel Roubini  already pointed out that Fed’s baseline scenario figures are wrong. For example, unemployment rate for Q1 2009 is 8.5% that is even higher than 7.8% projected by Fed for adverse scenario. You can read more about Nouriel Roubini’s views on stress test here. Federal Reserve may adjust their baseline scenario when they release the basic details of the stress tests tomorrow.

Overall, stress test is a good thing. It’s better to find out about severely crippled banks before they become another gigantic failure. I believe that Federal Reserve should conduct these stress tests every three months until we get out of this nasty recession.